Investors reacted to Tuesday’s election results by selling stocks. The Dow Jones Industrials Average fell 2.4% last Wednesday, though that was less than the nearly 5% drop after the 2008 election. With the election behind us now the “fiscal cliff” looms a few weeks ahead if President Obama, House Speaker Boehner and Senate leader Harry Reid can’t come together to pass some new legislation.
Unfortunately this trio’s track record for the past two years is not good. According to a New York Times article in September, “The 112th Congress is set to enter the Congressional record books as the least productive body in a generation, passing a mere 173 public laws as of last month.” It’s no wonder investors are nervous.
As we look to the investment markets, though, we need to step back and try to tune out the tremendous amount of political rhetoric we’ve all consumed this year. The simple fact is that regardless of what Washington does they really have little control over the economy. Over the past 50 years federal spending has averaged just 20.5% of American GDP (source: JP Morgan). And even with that 20% it doesn’t make a big difference as to which party is in control as the spending will be largely the same. They can tinker at the margins with various tax rates and spending priorities but at the end of the day neither party really can control the $16 trillion US economy.
Making the US politicians even less relevant is our increasingly global economy. The US GDP makes up a mere 19% of global production according to figures from JP Morgan. So when you consider that US federal government spending accounts for less than 4% of global GDP then you can see that, regardless of how the fiscal cliff issue is resolved, it’s really much ado about nothing, at least in global economic terms.
As we look to the investment markets stocks continue to be an attractively valued, yet unloved asset class. Investors have pulled a net of about $93 billion out of stock mutual funds so far this year while investing over $265 billion into bond funds according to the Investment Company Institute.
As we’ve discussed all year investors continue to act in a fearful and irrational way. Bond yields today are under 2% while stock dividends are above 2% and companies are able to reinvest over 5% above the dividend payout to grow their stock price. Through last week the average Large Cap Blend mutual fund is up 10.4% for 2012 while the average Intermediate Term Bond fund is up 7.0% according to Morningstar.
What investors fail to understand is that bond yields simply can’t go much lower. Investing into a bond fund today with a current yield of 1.7% means that you’ll earn 1.7% for the next year if interest rates stay at the current low level. If rates rise back toward more normal levels the bond price will drop resulting in a total return loss. Even if bond yields were to fall to below 1% most bond fund’s total return would still only be about 5% for the next year. And with just a 1.7% interest yield, rates don’t have to rise very much to generate losses.
Stocks, on the other hand, are cheap by most any measure. Corporate earnings may stagnate in the year ahead as the global economy struggles to advance but those earnings are still very attractive and will easily cover the dividends. With less than a third of the earnings going to dividend payouts companies are left with plenty of money to buy back shares, make acquisitions, invest in R&D, or use other methods to increase their stock price. If Washington can come together to mitigate the fiscal cliff stocks could advance nicely.