I am getting asked a lot lately if I watched any of the speeches at either political convention. A corollary question often follows – How is the election outcome likely to impact the economy and markets? I didn’t watch a single minute of either convention, on purpose. None of it, on neither side. Reminds me of this story…

A teenager borrows his dad’s car to attend his senior prom in high school. The evening goes particularly well. In fact, he falls in love, has the romantic evening of his life, but on the way home he sideswipes another car putting a big dent along the passenger side of his dad’s car. When he gets home, his dad asks, “How was your evening?” His son replies, “The prom was amazing, I had a great time.” Then he goes upstairs to bed.

Was he being honest? Technically, yes. Comprehensively and morally? Of course not.

That, in a nutshell, is why I don’t listen to political speeches or sound bites, especially during an election campaign.

How important is the election outcome to the economy and markets? While there are only four basic election outcomes, there are several more potential scenarios involving substantive change to legislative and regulatory policy. Let me try to explain. Assuming the House is not in play, the first two potential outcomes are: The Republicans win the presidency and hold the Senate, or they win the presidency but lose the Senate. Conversely, the Democrats could win the presidency and the Senate, or just the former, but not the latter. Four potential outcomes. However, it is unclear what any new administration or Congress will then attempt to accomplish, particularly if we have split government. Beyond that, even if the Democrats sweep, it is unclear in what direction they will turn. Will they begin with more “moderate” initiatives or try to push a more “radical, progressive” agenda? The net of all this is that there is too much uncertainty to make significant investment bets which are dependent on a certain election outcome. It will be important to be ready to adapt and adjust portfolio strategies. Depending on which party garners the most political power, there may be significant winners and losers across multiple industries and sectors. Virtually every aspect of our economy is subject to political developments, but they are difficult to predict and subject to continual revision.

Enough about politics. What else matters?… The Fed has signaled that interest rates are likely to remain near zero for an extended period. With the federal debt and deficit seemingly out of control they have little choice. Zero interest rates create a powerful tailwind for stock price valuations. But this valuation tailwind does not blow uniformly. With the post-Covid shutdown-economy still struggling to recover, earnings growth has been lackluster across most of the corporate sector. At the same time, driven by innovation and changing demand trends, several companies have managed to exceed earnings expectations and achieve accelerating profit growth. For these select companies, the valuation tailwind is like a powerful hurricane. In essence, it’s a “growth-scarcity premium” and it is extremely powerful. Going forward, it is likely to propel valuation on successful growth stocks much higher than historical levels.

Nothing grows to the sky… It is important to be ever vigilant to valuation levels achieved by these growth-scarcity winners. Moreover, if there is any crack in the fundamentals these stocks can plummet very quickly. Part of our ongoing research and portfolio management process is to continually retest and challenge the fundamentals of each of these leading companies. The art in this process is determining how long to let these winners ride as valuation levels expand beyond historical norms. There is a risk-management aspect to this as well. For each portfolio strategy, we set limits as to how big individual stocks can get in terms of the percentage of the total portfolio. This is one way to manage the risk in this environment of zero interest rates, slow economic growth, political uncertainty, and a stock market that keeps making new highs.

I am also frequently getting asked questions related to fairness. The question seems complicated to many, but maybe it shouldn’t be. Reminds me of another story…

When I was a young boy, my sister and I routinely fought over who would get to eat the last piece of pie. My mom solved this dilemma by giving each of us the choice of being either the one to cut the piece in half or the first to choose which slice they wanted to eat. Both of us learned that the only logical decision was to cut the piece exactly in half, which we did with incredible precision.

How broadly could we apply that approach today? I’ll give that some thought for next month’s edition of Exencial Views. In the meantime, send me your thoughts. Together maybe we’ll discover the whole truth, and nothing but the truth…

Michael Kayes, CFA

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