"Kee" Points with Jim Kee, Ph.D.

  • Midterm Elections
  • Interest Rates and Stocks
  • Growth Stocks and Value Stocks

Midterm Elections

Midterm elections (November 6) are getting so much attention that Barron’s published its first-ever policy-themed roundtable over the weekend on the subject. I’ll just summarize the consensus view, which was that Democrats will win control of the House of Representatives while Republicans will retain the Senate. That outcome, it was widely conceded by the Barron’s panelists, would be bullish for infrastructure spending in the U.S. As political strategist Greg Valliere has pointed out (not in Barron’s), even if we had a “blue wave” Democrat takeover of the House and the Senate, the business tax cuts already passed would be safe via President Trump’s veto power through 2020. Most felt that markets were fair-valued, and certainty not cheap. Abby Cohen of Goldman Sachs made the interesting point that Democrats are backing off of impeachment talk prior to the midterms for fear it might energize the Republican base. Dan Clifton at Strategas made the interesting point that the S&P 500 has not declined in the 12 months following midterm elections since 1946. 

Interest Rates and Stocks

Abby Cohen also talked about developed-world bond yields being too low, i.e. their bonds are overpriced, which makes U.S. yields attractive to them. “The global environment keeps our yields lower than they otherwise would be,” said Cohen. She also pointed out that 37% of the U.S. Treasury market is owned by non-Americans, as is 29% of the U.S. corporate bond market. Many fear higher rates here could put a damper on U.S. stocks by raising the rate by which corporate earnings are discounted (i.e. "the discount rate"), which would result in lower equity values. Without getting into the weeds of discounted cash flow modeling too much here, models that use the U.S. 10-year treasury rate to value the market are not very good at all! 

The discount rate is set by investors in the aggregate, with interest rates like 10-year treasury being a part of it. But so are investor's expected taxes (dividends and capital gains), expected inflation rates, and expected overall global risks or the “equity risk premium.” It is quite possible for interest rates to rise, but to have the overall negative impact of this rise on market valuations negated by offsetting positive changes in these other variables (including corporate earnings). For a simple example, interest rates as measured by the 10-year U.S. Treasury yields declined to a low of 1.37% in July 2016 before rising to current levels above 3%. That’s more than a doubling of interest rates, and yet during this rise equity market valuations increased 36%. This is partly because corporate tax cuts led to increased earnings, and the increase in earnings dominated or more than offset the increase in interest rates on overall market valuations.

Growth Stocks and Value Stocks

Finally, the lead article in this week’s Investor’s Business Daily caught my eye, “Growth Stocks Outrace Value.” Growth stocks have had such a dramatic run relative to value stocks since 2010 that they have now outperformed value stocks measured over the past three decades. I think that has led many investors to conclude that they should be allocated 100% to growth stocks. The article pointed out that the last time this occurred was just before the dot-com bubble burst, though that wasn’t a prediction. Interestingly, if you ran the data prior to this bull market, which economist Victor Canto did for his book, Understanding Asset Allocation, you would conclude that the ideal long-term asset allocation would be just the opposite - 100% value stocks! So the lesson of this bull market is that you don’t want to be invested 100% in value stocks, just like the lesson of previous markets is that you don’t want to be 100% invested in growth stocks. Owning both gives you the diversification benefits of two asset classes that tend to offset each other in the short run while both go up over time. In short, diversify. That’s what the Nobel Laureates mean when they tell you to usethe markets through diversification rather than trying to outsmart them.