Market participants breathed a sigh of relief in early November. The arrival of the long-awaited mid-term elections and the Federal Reserve (Fed) announcement of another stimulus program unfolded as anticipated.
Even though the major political headlines are out of the way, what happens in Washington during the remainder of the year will still hold influence over the markets. The most important item facing Congress is the looming expiration of the Bush tax cuts. Congress is likely to address the tax cuts in some way during the remainder of this year. Both parties risk a huge backlash if no action is taken and all tax rates revert to higher levels, which puts pressure on the 70% of the economy that is driven by consumer spending. Congress is likely to pass a one- or two-year extension of all the Bush tax cuts during the lame duck session, but it is a close call.
The market reacted favorably to election results and the Fed announcement, extending the trends in the markets and resulting in the S&P 500 reaching a new two-year high. However, the strong gains in September, October, and November were not powered by individual investors. For the first time in 25 years, a three-month gain in the S&P 500 of 10% or more was not accompanied by net inflows into individual investments—namely U.S. equity mutual funds and exchange-trade funds (ETFs). Fortunately, individual investor outflows have been more than offset by the buying of institutions and foreign investors. Nonetheless, individual investors have been net sellers of U.S. stock mutual funds every month since April of this year. In that time, they have pulled about $80 billion from the U.S. stock market*. This is not because individual investors have been avoiding investing entirely, however. Interestingly, they have been putting money to work in foreign stocks and U.S. bonds—including more aggressive emerging market stocks and high-yield bonds, as they reallocate money from cash and U.S. stocks.
Investors’ appetite for yield has prompted strong inflows into the high-yield bond market this year (Source: Investment Company Institute). The potential for extending the dividend tax rate at 15% (as opposed to reverting up to 39.6% for the top bracket), combined with the increases in dividend payments that traditionally come in the first several months of the year, may prompt individual investors to migrate from high-yield bonds toward high dividend-paying stocks furthering the stock market’s gains. This upside potential is balanced by the threat of potential selling by foreign investors prompted by the ongoing weakness in the dollar. As a result, the volatility that has been the key characteristic of this year’s stock market performance is likely to continue in to 2011. As always, please contact me if you have any questions.,
Greg Powell, CIMA