September has come and gone and we have exited the month following a period of unusual complacency, which is Wall Street speak for days upon days when the major market indices trade within an unusually narrow range.
Recall that last month we quoted a piece from LPL Research pointing out that the S&P 500 range for August was the seventh narrowest since 1928.
One thing that is absolutely certain – periods of sheer boredom for the short-term trading crowd will eventually come to an end. We don’t know when, but it will happen. In this case, a modest bout of volatility returned to the market by mid-September. Much of it was related to interest rate worries and chatter from various Federal Reserve officials.
Table 1: Key Index Returns
|MTD %||YTD %||3-year* %|
|Dow Jones Industrial Average||-0.5||+5.1||+6.6|
|S&P 500 Index||-0.1||+6.1||+8.8|
|Russell 2000 Index||+1.5||+10.2||+5.2|
|MSCI World ex-USA**||+1.0||+0.6||-2.3|
|MSCI Emerging Markets**||+1.1||+13.8||-2.9|
Source: Wall Street Journal, MSCI.com, MTD returns: Aug 31, 2016 – Sep 30, 2016
YTD returns: Dec 31, 2015—Sep 30, 2016, *Annualized, **USD
We’ll steer clear of the Fed in this month’s letter, but we did want to go into a bit of detail on a couple of items, including what we sometimes like to refer to as the “pink elephant in the room.” You know, something that everyone at the cocktail party is aware of it, but we all decide it’s best to pretend it’s not there with us.
Today’s pink elephant: the upcoming election.
No doubt, politics can fuel all types of emotions. We sometimes feel strongly about certain issues or certain candidates. It’s not uncommon to think, “How can anyone see things differently than I do?!”
And that’s when the fireworks begin.
So, recognizing that we all have our own political views and filters, we want to cautiously tiptoe into the minefield and help you see the election through the lens of the market. Admittedly, it’s a very narrow lens, but then, we are not a political analysts.
Your vote counts
The election is on everyone’s mind. In what was the first of three scheduled debates, the two major candidates came to blows on September 26.
If you happened to see some of the snap polls that were conducted immediately following the debate, Hillary Clinton came out on top (CNN). For that matter, most professional pundits saw it the same way.
During the debate, the Dow Jones futures, which, among other things, is a gauge that gives us an idea how stocks will open the next day, rose by about 100 points.
The positive reaction extended into the next day, telling us that the professional investment community was pleased with Clinton’s performance.
As dispassionate observers who are interested in viewing the election only through the objective prism of the market (admittedly a very narrow prism), the professional investment community sees continuity in a Clinton win, even if some in the community are more likely to subscribe to the economic and tax ideas of a Republican.
It’s that continuity that appeals to the desire for certainty. As we’ve mentioned many times in the past, short-term traders fear heightened uncertainty. It’s the vagueness of some of Trump’s ideas, coupled with his rhetoric, that fuels uncertainty.
Of course, this is not an endorsement of either candidate. Let us also emphasize that short-term market volatility shouldn’t determine how anyone votes in November. The nation faces much more pressing issues.
Instead, it is more akin to the idiom, “Better the devil you know than the devil you don’t,” at least in the eyes of Wall Street.
We do, however, want to monitor important events that may create some ripples in the financial waters, even if those ripples are brief in nature.
That leads to my next point. Keep your eye on your longer-term financial plan. While we’ve seen very little market volatility tied to the election, it’s possible things could get a bit bumpy as we approach election day.
You’ve heard us reiterate time and time again: Markets go through choppy periods over the short term, but a disciplined approach is the straightest line to your financial goals.
No doubt if you fly at all, you have experienced some turbulence at some point. This choppiness in what might otherwise be a smooth flight is typically short term and has no lasting effect on the safety of your arrival to your desired destination.
The German version of too big to fail
Investors are living in the shadow of 2008. While the wounds have healed for those who maintained a disciplined approach, the scars may still run deep.
And that means some investors have a tendency to look over their shoulder, always wary that another crisis is lurking, ready to ambush them.
The latest such instance hails from Europe – Germany to be specific.
Deutsche Bank (DB $13) is Germany’s largest bank. With assets that total nearly $2 trillion, it is Europe’s fourth largest bank by assets.
Safe to say, it’s too big to fail.
Unlike their U.S. counterparts, which diligently raised capital in the post-2008 era, Europe’s banking system is in a much more fragile state. And right now Deutsche Bank is the poster child for ailing European banks.
At the end of the second quarter, the International Monetary Fund said Deutsche Bank posed the greatest risk to the global financial system. In part, problems spring from profitability issues and the lack of a solid capital buffer.
Fast forward to mid-September, when Deutsche Bank was asked by the U.S. Justice Department to pay a $14 billion fine for selling to toxic mortgage securities. It was a punch to the gut for a bank that was already wobbly.
Then, two ill-timed stories hit the wire near the end of September. German Chancellor Angela Merkel reportedly ruled out any state assistance for the bank (denied by both parties), and about 10 hedge funds that do business with the bank moved to reduce their exposure.
Today, it is an issue of confidence.
The bedrock of the financial system
The foundation, the bedrock, the cornerstone (we can’t over-emphasize this) of the global financial system is confidence.
Simply put, we hold our cash in banks. At any time, we have the confidence we can walk into our local branch and withdraw the entire amount.
But, if everyone shows up at once, it would amount to a run on the bank.
If confidence evaporates and it happens to a “too-big-to-fail bank,” tremors can quickly spread around the globe, as we saw in the wake of Lehman’s failure in 2008. It’s like throwing a giant wrench into the gears of the financial system.
We don’t believe Deutsche is a Lehman moment
What ails Deutsche Bank also dogs many of Europe’s large banks, all of which are grappling with a number of headwinds.
However, we believe the 2008 crisis was a once-in-a-lifetime event. Investors must be careful not to believe the sky is falling every time rain makes its way into the forecast. Such a posture will lengthen the path toward your financial goals.
What’s different today, you ask? Unlike 2008, central banks and governments are painfully aware of the carnage that was sparked by Lehman’s disorderly demise.
Additionally, U.S. banks are much better positioned today. The economic fundamentals aren’t deteriorating, and banks aren’t floundering under the weight of toxic assets.
While EU banking rules have been designed to limit taxpayer support of large institutions, it’s hard to see a situation where Germany would allow a disorderly dissolution of its largest bank. Such an event would wreak havoc on its economy.
Moreover, firewalls are now in place that weren’t available in 2008.
It’s not that we can’t see some volatility if problems persist, but U.S. fundamentals, which have helped support shares during periods of recent volatility, remain intact.
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