The Pink Elephant and a European Bank

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3rd Quarter Market Commentary

October 2016

It is hard to believe that we are entering the 4th quarter of the year.  September has come and gone and we have exited the month following a period of unusual complacency.

Complacency is Wall Street speak for days upon days when the major market indices trade within an unusually narrow range.

LPL Research put out a piece in September 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
NASDAQ Composite +1.9 +6.1 +12.1
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

I’ll steer clear of the Fed in this month, but I did want to go into a bit of detail on a couple of items, including what I 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, including myself, I 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, I am not a political analyst.

I am a financial advisor, your financial advocate, and it is my sincere desire to earn a trusted role as your financial confidant. For some of you, I already have. I am here to join you on life’s journey toward your financial goals, not pontificate on what are, admittedly, the important issues of the day.  With that said.

Your vote counts

The election is on everyone’s mind. I have had several clients call me wanting to discuss the potential market scenarios related to the election.

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, I noticed that 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 (MarketWatch).

The positive reaction extended into the next day, telling me that the professional investment community was pleased with Clinton’s performance.

Please stay with me and let me explain.

As a dispassionate observer who is 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 I’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 me also emphasize, short-term market volatility shouldn’t determine how you and I vote 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.

I 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 volatility tied to the election, it’s possible things could get a bit bumpy as we approach election day.

You’ve heard me 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.

Trying to time the highs and lows in stocks is much like trying to guess the string of plays your team will call as it hopes to charge down the field and score a touchdown. Or, it’s analogous to trying to guess what the score might be midway through the fourth quarter, when your team sports a 21-9 lead heading into the locker room at halftime.

I enjoy listening to the keen insights of sport professionals during the halftime show. But none of them offer up a prediction of the final score. As baseball great Yogi Berra was fond of saying and I’m fond of quoting, “It’s tough to make predictions, especially about the future.”

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 tower nearly $2 trillion, it is Europe’s fourth largest bank by assets (Statista.com).

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 (Wall Street Journal). 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 (Wall Street Journal). 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 ten hedge funds that do business with the bank moved to reduce their exposure (Bloomberg).

Today, it is an issue of confidence.

The bedrock of the financial system

The foundation, the bedrock, the cornerstone (I can’t over emphasize this) of the global financial system is confidence.

Simply put, you and I 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 be 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. It’s like throwing a giant wrench into the gears of the financial system.

I don’t believe Deutsche is a Lehman moment

Bad things can happen; I won’t deny that. I really do understand that some of you have concerns. If you would like to talk, you know I am always available to address any issues.

What ails Deutsche Bank also dogs many of Europe’s large banks, all of which are grappling with a number of headwinds.

However, I 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 (Financial Times), 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.

I hope you’ve found this review to be educational and helpful. As I always emphasize, it is my job to assist you. If you have any questions or would like to discuss any matters, please feel free to give me a call.

 

The economic forecasts set forth may not develop as predicted and there can be no guarantee that strategies promoted will be successful. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results.

No strategy, such as diversification, can assure success or protect against loss in periods of declining values.

Investing involves risk, including loss of principal

The Dow Jones Industrial Average is comprised of 30 stocks that are major factors in their industries and widely held by individuals and institutional investors. All indexes are unmanaged and an individual cannot invest directly in an index Unmanaged index returns do not reflect fees, expenses, or sales charges. Index performance is not indicative of the performance of any investment. Past performance is no guarantee of future results. The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. The NASDAQ Composite Index measures all NASDAQ domestic and non-U.S. based common stocks listed on The NASDAQ Stock Market. The market value, the last sale price multiplied by total shares outstanding, is calculated throughout the trading day, and is related to the total value of the Index. The MSCI EM (Emerging Markets) Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of the emerging market countries of the Americas, Europe, the Middle East, Africa and Asia. The MSCI EM Index consists of the following emerging market country indices: Brazil, Chile, Colombia, Mexico, Peru, Czech Republic, Egypt, Greece, Hungary, Poland, Qatar, Russia, South Africa.Turkey, United Arab Emirates, China, India, Indonesia, Korea, Malaysia, Philippines, Taiwan, and Thailand

The Russell 2000 Index is an unmanaged index generally representative of the 2,000 smallest companies in the Russell 3000 index, which represents approximately 10% of the total market capitalization of the Russell 3000 Index. The MSCI World ex USA Index captures large and mid cap representation across 22 of 23 Developed Markets (DM) countries*–excluding the United States. With 1,023 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.