PODCAST Episode 26 – September May Be Choppy, But Will There Be An October Surprise?

In this episode Richard Calhoun, CEO of Laidlaw Wealth Management, discusses shifts in investment frameworks, the Fed, the Apple share split and other developments with Laidlaw & Company Chief Market strategist, David Garrity.

The topics discussed in this episode are: What investment frameworks are being broken and remade?, What was the import of Fed Chair Powell’s speech last week?, If long-term Treasury yields rise off Powell’s speech, what will happen with the muni market absent fiscal relief?, What is the importance of the Apple stock split?, and With the S&P 500 extended, will October offer a surprise to keep the rally going? 

Please tune in for more timely insights.

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Hello and welcome to another episode of “A Brighter Future” Laidlaw & Co.’s Podcast Series.  I’m Rick Calhoun, CEO of Laidlaw Wealth Management, and once again I am joined by David Garrity, Chief Market Strategist for Laidlaw & Co. 

David, I hope you had a nice weekend. In most parts of the east coast, the weather was a bit unsettled as the remnants of Hurricane Laura made their way thru, but last week the markets 

were anything but unsettled. We saw markets finish higher, on track for the best August in 34 years, and continuing the rally after the third bear market in two decades. 

The S&P 500 is now up nearly +52% since the bear market bottom on March 23, and is up nearly +8% for the year, posting a new record high of 3,494.

Personal spending rose +1.9% in July, the third month in a row showing growth, indicating that the economic recovery is underway and the  Federal Chairman, Jerome Powell, stated that the Fed will let inflation run slightly higher than the traditional +2%, meaning rates will stay lower for longer, which is a tailwind for equities.   

So, David let’s start our discussion here:

Rick, the weekend offered a good chance to pause and reflect again on the apparent disconnection between the ever-elevating financial markets and the COVID-19 Coronavirus (“COVID”)-driven disarray of the global political economy. 

The best response I can offer is that we are seeing old paradigms that are being broken and new frameworks that are being put in place. 

Relative to monetary policy, Federal Reserve Chairman Jay Powell’s speech last week indicated that the Federal Reserve has moved off the anti-inflation policy priority that had been installed 50 years ago by then Fed Chair Paul Volcker who physically passed in December 2019. 

Relative to the stock market we have seen what some have called a bull market for algorithms and a bear market for humans as technology companies with a high ratio of intangible assets per employee have massively outperformed those with a high ratio of physical assets per employee. Clearly, man is no longer the measure of all things that he used to be. 

As to July’s strong Personal Spending growth, we will have to see how well that holds up as fiscal COVID relief programs have run out with little prospect of renewal until the end of September and more likely until after the November election. 

This coming Friday’s August Employment Report will also make for interesting reading, so brace yourself for a not-so-quiet week heading into the summer-ending Labor Day weekend. 

Question 1  

At the annual Jackson Hole policy symposium Chairman Powell announced a shift in the Fed’s approach to achieving its long-term average inflation target. His statement read: “Our revised statement says that our policy decision will be informed by our ‘assessments of the shortfalls of employment from its maximum level’ rather than by “deviations from its maximum level” as in our previous statement. This change may appear subtle, but it reflects our view that a robust job market can be sustained without causing an outbreak of inflation,” 

So what does this mean to our listeners David? 

Rick, it has been clear from the Federal Reserve’s monetary policy actions since the onset of COVID that interest rates will likely to remain at a zero level for an extended period of time, perhaps as far out as the next five years given the extent of damage that COVID has wreaked on the global economy’s growth potential. 

In his speech last week, Powell has formally shifted the operational emphasis of the Federal Reserve from an emphasis on the price stability objective in its dual policy mandate over to an emphasis on the employment promotion objective. In short, the Fed is now squarely in a pro-nominal growth policy stance and as indicated earlier former Fed Chairman Paul Volcker’s anti-inflation policies are now clearly a ghost. 

With this move, Powell has taken the fear of negative interest rates out of the market, something clearly reflected in the Fed Funds Futures curve out to July 2022. How soon long-dated Treasuries sell off in expectation of the eventual rise in the inflation rate remains to be seen, but a steepening yield curve is the part of the capital markets picture of the early stages of an economic recovery that has up until now been missing. 

Not sure investors are prepared for the prospect of 2% 10-year Treasury yields, but with last week’s speech the stage is being set for just that possibility.   

Question 2

David, there was some news last week about the Dow Jones Industrial Average getting a revamp.  In the biggest adjustment to the index since 2013, S&P Dow Jones Indices announced that Salesforce.com, Amgen, and Honeywell International Inc. will replace Exxon Mobil, Pfizer, and Raytheon Technologies Corp. effective September 1. 

The addition of Salesforce and removal of Exxon, which was the most valuable U.S. publicly traded company as recently as 2014, is the main headline and was triggered by Apple’s 4-for-1 stock split.

So let me ask you a few questions on this topic:

  1. Why did Apple’s decision to split their stock impact the rest of the Dow holdings? 
  2. Does being added or removed from an index change the fundamental value of a business? 
  3. Does the Dow Jones index really matter anymore?   After all, the S&P 500 is a broader index, and more representative of the U.S. large-cap universe. In fact, I saw a statistic that approximately $28 billion uses the Dow as a benchmark versus over $11 trillion that is benchmarked to the S&P 500! 

Rick, in short, the decision by Apple on a 4:1 stock split prompted a move by the Dow Jones index committee to reconstitute the index as the split would take Apple’s index weighting down from 12% to 3%. The decision by Apple to split the stock was driven by an interest in making it easier for individual investors to purchase a round lot of shares. On its own, a stock split does not change the underlying value of a business. A better signal of underlying value is dividend policy. If a stock split is accompanied with a dividend increase that should be seen as supporting an increase in valuation. Otherwise, the split means little in value terms. 

As you mention, the Dow Jones Industrial Average (DJIA) is a price-weighted index of 30 large-cap companies whereas the S&P 500 is a market-cap weighted index of 500 companies. Most importantly, more investment capital is benchmarked to the S&P 500 than the DJIA. While the changes in the DJIA are significant for the companies involved, the fact that the DJIA is largely insignificant as an investment benchmark means that being excluded or included should have minimal impact on the share performance of the companies involved. What is important here is that even with the changes made to the DJIA the tech sector weighting at 23% post-shift will still lag the 28% tech sector weighting in the S&P 500 index.  

Question 3

David, let’s shift gears and talk about a topic that Barron’s wrote about this weekend, the fate of the Municipal Bond Market.  

Many of our listeners have been Muni Bond buyers for years but with yields right now at 0.7% for top-rated 10-year muni a growing number are getting cautious on the market as that yield may not be enough to compensate investors for the risks that many municipalities are set to face.  

With so many businesses closing and so many people either out of work or working from home, revenues from sales and income taxes are way off. Ditto for gasoline taxes, tolls for bridges and tunnels, public transit fares, and airport fees.

In all, states are facing a budget shortfall of $555 billion for the three years through June of 2022 and for cities and towns, it’s an additional $360 billion for the three years through December 2022.  That’s close to a trillion dollars!!! 

So, should we expect that many municipal bond issuers won’t be able to repay on their bonds? Also, what should long time Muni Bond buyers be aware of when evaluating new bond investments? 

Rick, as you clearly spell out, unless the next fiscal COVID relief package includes meaningful aid for state & local governments the capital markets fall out for the municipal bond market could be quite negative as existing debt will need to restructured and new debt issued at much higher interest rates. 

Fed Chair Powell wants to see rates at the long end of the Treasury yield curve rise. With munis priced off the curve, the outlook for a correction in the muni market is growing by the day.

Question 4 

David, as near the end of another episode,  I want to ask you what may seem like a strange question, but what gives with September and the Financial Markets?   

September’s reputation as a poor month for equities is well-known. In fact, since the Dow Jones Industrial Average was created in the late 1800s, the Dow has fallen an average of -1% in September, while it has gained on average +0.7% in all other months.  I have heard lots of opinions, but one of my favorites is that the stock market in September suffers from pent-up selling from investors who are just returning from their summer vacations.  

So, is everyone going to unpack their suitcases after Labor Day and then unload their portfolios? 

Rick, as of last Friday’s close, the S&P 500 was up +13.15% to date for Q3 2020. That is a great deal of return for an environment in which one may argue that a wide variety of risks have not been mitigated. 

Consequently, it is quite possible that as investors awaken from the summer reveries to consider the world in the cold harsh light of September that a certain reassessment of risks & returns should be in order. Right now, the S&P 500 is more extended further above its 200-day average than at any time but one in the past decade. So, no one should be surprised by a pause or sharp pullback for any reason or none at all.

On the other hand, a review of earnings expectations for H2 2020 show that very little, if any, of the substantial Q2 2020 earnings season’s outperformance has been factored in. That said, we should consider that the Q3 2020 earnings season will see something of a replay as companies surprise to the upside. This is likely to be the October Surprise that keeps the S&P 500 index on track to reach our 2020 price target of 3800. 

So, the word for September may be to view the market cautiously, but keep some capital available for October.