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Election fears weigh on stocks, S&P 500 down 1.9%

The most common cause of low prices is pessimism – sometimes pervasive, sometimes specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. – Warren Buffett

The S&P 500 Index fell nearly 2% last week and was down for the ninth consecutive day on Friday as recent polls indicated that the U.S. presidential race was becoming closer with the eventual outcome clearly in doubt. The stock market had priced in a victory by Democratic nominee Hillary Clinton but all bets are off now as Republican nominee Donald Trump has closed the gap in recent weeks, causing anxiety among investors uncertain of the effect of his trade policies on the economy. Worries over the election overshadowed mostly positive economic data last week as well as better than expected third quarter earnings results. With about 85% of companies in the S&P 500 having reported earnings, slightly more than two-thirds of them have exceeded expectations and average earnings growth has been about 2.7%. If this trend holds, it would end the longest earnings recession since the financial crisis and mark the first increase in quarterly earnings since March 2015. The results of the Federal Open Market Committee (FOMC) meeting last week also went unnoticed as the Fed decided to leave interest rates unchanged but acknowledged that solid job gains and increased consumer spending have strengthened the case for increasing rates. It now seems like a foregone conclusion that the Fed will raise the federal funds rate by 25 basis points at its December meeting. The October employment report, which showed that the U.S. economy added 161,000 new jobs, seemed to take a back seat to the presidential election, too. Although the number of jobs created was less than expected, both August and September job numbers were revised higher and the unemployment rate edged lower to 4.9% from 5.0%. More importantly, average hourly earnings rose 10 cents for an annualized increase of 2.8%, the best wage growth in seven years. This jobs report was considered positive from an investor’s standpoint, but all but lost in a week where everyone was fixated on the election and nervous about the range of possible outcomes.

Last Week

For the most part, the economic data released last week was mostly positive. Consumer spending, which accounts for about 70% of U.S. economic activity, was better than expected in September and U.S. factory orders also exceeded estimates. Although manufacturing has been hurt by a strong dollar and weak global demand, there is cautious optimism for a turnaround. The ISM manufacturing index in October was in line with estimates and barely in expansion territory while the ISM non-manufacturing or services sector index was below estimates but still showed solid expansion.

The Energy Information Administration (EIA) reported a record oil inventory increase last week, causing a drop in the price of oil to about $44 a barrel. OPEC issued a statement on Friday, though, that said they were very optimistic about reaching an agreement to cut oil output later this month. In a speech on Friday, Atlanta Fed President Dennis Lockhart said that any Fed rate hikes over the next two years would be very gradual.

For the week, the Dow Jones Industrial Average lost 1.5% to close at 17,888 while the S&P 500 Index fell 1.9% to close at 2,085. The Nasdaq Composite Index declined 2.8% to close at 5,046.

This Week

The focus this week will be on the U.S. presidential election on Tuesday as well as contests for senators and members of the House of Representatives. There will be a dearth of key economic data this week with the preliminary November Michigan sentiment index, September consumer credit and September wholesale inventories being the only releases on the calendar. Several Federal Reserve officials are also scheduled to speak and China reports producer and consumer price data.

As earnings season winds down, the most notable companies scheduled to report their profits this week are Sysco, International Flavors & Fragrances, CVS Heath, Viacom, Walt Disney, Marriott International, D.R. Horton, Johnson Controls, Nordstrom, Kohl’s, Macy’s and J.C. Penney.

Portfolio Strategy

Investors have recently become so obsessed with the outcome of the U.S. presidential election that they have overlooked a number of positives with regard to the economy and corporate earnings. Although gross domestic product (GDP) averaged only 1.1% in the first half of the year, GDP improved to 2.9% in the third quarter and there are no signs of a recession anywhere on the horizon. One of the best predictors of a recession is an inverted yield curve (yields on short-term Treasuries exceed those of long-term Treasuries), but that is clearly not the case now as the yield curve is upward sloping with a yield of 0.80% on the 2-year Treasury, 1.78% on the 10-year and 2.57% on the 30-year. The Federal Reserve will probably raise the federal funds rate at their December meeting, but the increase will only be 0.25% and any hikes thereafter will likely be only gradual and dependent on economic data. Third quarter earnings results have also been surprisingly strong relative to expectations and will probably show positive growth for the quarter, something that was not expected going into this earnings season. Despite all of this positive news, many strategists have become downright bearish on the stock market, which generally is a contrarian signal that stocks are set to rise. The biggest reason for the decline in the stock market for the last nine consecutive days has been the uncertainty over the election. But the odds are still strongly in favor of divided government regardless of who is elected president, a condition that the stock market usually prefers. That scenario, coupled with an improving economy and better corporate earnings, should enable the stock market to recover from its recent losing streak as it heads into what historically has been the best period for performance – November thru April.