— 2020 Q4 UPDATE —

The fourth quarter of 2020 was chock full of market moving events which included an election cycle (in-depth analysis on Georgia’s run-off elections further down), record numbers of Covid-19 cases and deaths, the development and distribution of a Covid-19 vaccine, a $900 billion Covid-19 relief package (analysis further down), and a plethora of other things that will not fit in this market update.

As investors, the importance of being able to analyze the world around us cannot be overstated but analysis is only part of a successful investment process. An often overlooked feature of creating a successful investment process is figuring out what to analyze in the first place. In a world which constantly floods us with endless streams of dynamic and complex information, it can seem like a daunting task to accurately assess what you are analyzing, let alone figuring out which companies, events, or countries to pick in the first place. This is where the importance of an investing framework comes to the forefront. An investing framework is critical because it gives investors tools to filter information into digestible buckets. Once the information is filtered, it becomes much easier to distinguish the signal from the noise which allows you to spend time researching the right things. It does not matter how good of a fisher you are if you are trying to fish in the middle of the desert!

Summary:

• It will attempt to give a framework for filtering market events into two different categories which will be classified as Beta vs. Alpha events.

• It will cover the important details of the $900 billion Covid-19 relief package.

• It will cover the implication of the Georgia election giving Democrats majority control over the Senate and what Democratic policy preferences have the highest likelihood of passing.

Read on for our full Q3 market update and how these factors could impact the economy and your investments…

Investing Framework - Beta events vs. Alpha events:

Beta Events:

Beta events are events that market participants have ample, accurate, and up-to-date information about. This combination allows market participants to attach a relatively accurate probability of whether an event will take place, the likelihood of different outcomes occurring, and how each particular outcome will affect the valuation of an asset. For example, under these conditions, the Presidential election would be classified as a beta event because there was ample, accurate, and up-to-date information surrounding whether the event would take place or not, likelihood of different outcomes, and the policy preferences of each candidate which would affect assets differently. I am classifying these events as beta events because it is important to understand the difference between information that is likely to give an edge when investing versus information that is already absorbed by the market. 

Understanding beta events on a fundamental level is critical as a foundational piece of investing but it is only the beginning. Investing based on accurate assessment of beta events should earn a risk/return profile that is in line with general market because of the market’s pricing mechanism. Investing solely on this information and expecting a better risk/return than the general market is like taking the same freeway as everyone else and expecting your drive to be more efficient than the other drivers on the same freeway. When you are driving on the freeway you may be able to get to places faster (higher return) by speeding or weaving through traffic (higher risk) but you cannot actually get to places faster while going the same speed as everyone else (generate a better risk return profile). This style of investing is essentially what passive investing encapsulates through tracking an index.

An example showing the dichotomy between how the market reacts to information that is not priced in versus information that is priced in is exemplified through Covid-19. In March of 2020, markets around the world reacted violently to the spread and initial deaths of Covid-19 because market participants were trying to analyze and price in the situation in real time. Fast forward to Q4 of 2020 and the virus has become a pandemic that is killing thousands of people around the world every day and is consistently distributing the world economy and to an investor that does not understand the pricing mechanism of the markets it may look as if the market is simply ignoring reality. The tremendous volatility experienced early in the year was the market going through the growing pains of incorporating the new information into market prices. As of Q4 2020, the market has a good understanding that Covid-19 is here until further notice (event taking place), a good understanding of the different possible scenarios of Covid-19 in the near future (probability of return to normalcy from a vaccine or continued lockdowns), and how these different scenarios will affect the valuation of asset prices. Therefore, Covid-19 is currently a beta event. 

Alpha Events:

Alpha events are events in which market participants do not have ample, accurate, or up-to-date information. Unlike beta events, which need to have all 3 to be a beta event, alpha events only need to have 1 of these 3 items to be an alpha event. For example, an event that has ample and up-to-date information that is not accurate will be classified as an alpha event. I am calling these alpha events because investors who estimate and act upon these events with more accuracy than the general market should be able to generate alpha. Alpha generation is simply another way of saying an investor will generate a better risk/return profile than should be possible through investing in an efficient marketplace. Returning to the driving analogy, this would be like knowing a shortcut that allows you to get to your destination quicker (higher return) while driving the same speed (same risk), this leads to a faster and safer journey than could be achieved driving with all the other cars on the freeway. 

The goal of creating a better risk/return profile than the general market is the goal of most active management. Since everyone would like a better risk/return profile, an astute reader may ask why anyone would choose the passive over the active style of management. There are two main reasons. First, the information gathering and analysis that active management must do to produce alpha is expensive. It costs money for that new GPS to tell you about the special shortcut that very few people know about and even if you get to your destination more efficiently, it may not have been worth the extra expenses. Second, even with pricey information gathering, there is the potential that the shortcut ends up being the opposite of a shortcut and it would have just been better to stay on the freeway with everyone else.

Fiscal Stimulus:

During the beginning of the pandemic, Congress passed the CARES Act which came at a price tag of around $3 trillion. This unprecedented fiscal relief package touched myriad parts of the economy and was covered in depth in my Q1 update. Fast forward to the fourth quarter of 2020 and Congress passed another Covid-19 relief package which provided around $900 billion of fiscal stimulus. According to Politico, “The colossal year-end package – approved by the House and then the Senate – will provide another round of direct payments, enhanced unemployment benefits and billions of dollars for struggling industries.” While smaller in scale than the CARES Act, this stimulus package also touches many parts of the economy and as investors it is vital to understand the flow of money throughout the economy. 

Breakdown of the stimulus package (Source Politico):

• $166 Billion in Direct Checks: Individuals making up to $75,000 a year will receive a payment of $600, while couples making up to $150,000 will receive $1,200, in addition to $600 per child.

• $120 billion in extra unemployment benefits: Unemployed individuals, included the self-employed, gig workers, and those who have exhausted their state benefits, will receive an extra $300 per week through March 14^th.

• $325 billion for small businesses: This includes $284 billion in loans through the Paycheck Protection Program, $20 billion for businesses in low-income communities and $15 billion for live venues, movie theaters and museums.

• $45 Billion in Transportation Aid: Includes $15 billion for airlines to maintain payrolls, $14 billion for mass transit, $10 billion for state highways, $2 billion for airports and $1 billion for Amtrak.

• $26 Billion for Food and Famer Assistance: Includes $13 billion to increase food stamp benefits by 15% and another $13 billion for direct payments to farmers to help cover pandemic-induced losses.

• $54 Billion for Vaccines: Includes $20 billion for the purchase of vaccines, $9 billion for vaccine distribution, $3 billion for the National Strategic Stockpile and $22 billion to help states with testing.

• $25 Billion in Rental Aid and an Eviction Ban: Federal eviction ban has been extended through the end of January and $25 billion is given towards federal rental assistance, with $800 million of that for Native American housing entities.

• $91 billion for Education: Includes $54 billion for public K-12 schools, $23 billion for higher education, $4 billion for a governors’ relief fund, and the child care sector will receive $10 billion in emergency cash.

• $7 billion for Broadband: Invests $7 billion to expand broadband access for students, families and unemployed workers. This includes $300 million for rural broadband and $250 million for telehealth.

•  An Extension for State Spending: States and local governments will have until Dec. 31, 2021 to spend aid provided by the CARES Act. 

With the plethora of spending from the stimulus bill getting the majority of the headlines, an overlooked, but important feature of this stimulus package, was how it impacted a number of tax incentives.

Breakdown of the Tax Incentives (Source Accounting Today):

• The Craft Beverage Tax Relief: Provides excise tax relief to the craft beverage industry.

• The Medical Expense Deduction Expansion: Extends this CARES Act benefit for an additional year.

• The Employee Retention Tax Credit: Extends the credit until June 30, 2021 and expands the credit by providing a 70% credit for up to $10,000 in creditable wages per quarter and reducing the gross receipts decline to 20% from 50%.

• CFC look-through Rules: Extends the rules that allow U.S. multinational corporations to efficiently bring back dollars trapped overseas by 5 years.

• The Health Coverage Tax Credit: Extends credit for one-year which helps subsidize the cost of continued coverage for retirees and other individuals who lost their health care coverage, pensions, and other benefits at a result of being laid off or their employers going bankrupt.

This stimulus bill that built on top of the CARES Act was the final stimulus package of 2020 and a lot of investors believed it would be the final Covid-19 relief package altogether. However, those beliefs changed when the final results of the Georgia run-off election took place.

Political Economy:

This update was delayed because of the uncertainty surrounding how the United States government would be constituted after the Georgia run-off elections were held on January 5^th. Before the election took place, Republicans held a 50-48 lead in the Senate which placed them 1 senator away from a 51-seat majority. This run-off election took national spotlight because if the Democrats won the Georgia elections, Democrats would control the House of Representatives, the Senate, and the Executive Branch. Ultimately, as I am sure everyone knows by the time of reading this, Democrats won both races in Georgia to give them a 50-50 tie in the Senate with Kamala Harris having the tie breaking vote, essentially giving the Democrats a 51-50 majority in the Senate.

This Senate majority gives Joe Biden more power to enact the legislation he committed to during his Presidential run, but it does not give unlimited power as some may think. As investors, it is important to understand the differences between politicians’ policy preferences and the constraints faced in enacting their preferences through legislation. Investors can get themselves in trouble by making emotional decisions while in a feverous state because they misunderstand the constraints placed on political preferences. Therefore, to figure out what new policies are likely to come into law, we must figure out what the political preferences are for the Democrats and how the process of making those preferences come to fruition actually works. Through understanding the process, the preference constraints will naturally reveal themselves and we should have a higher probability of predicting what will be passed.

Main Policy Preferences (According to Joebiden.com):

• Healthcare reform
• Tax increases
• Renewable energy
• Covid-19 Stimulus packages
• Police reform
• Gun control
• Minimum wage laws
• Infrastructure spending

General Process of Passing New Legislation (According to Whitehouse.gov):

• Member of Congress (House or Senate) introduces a bill.
• Bill is referred to the appropriate subcommittee for review where it may be accepted, amended, or rejected entirely. If it is accepted at the subcommittee level, it is passed to a full committee where the same process is repeated. Throughout this whole process, the subcommittees and full committees invite experts, advocates, and opponents to appear before the committee and provide testimony. 
• If the full committee approves the bill, it is reported to the floor of the House or Senate, and the majority party leadership decides when to place the bill on the calendar.
• When the calendar date arrives, the debate process happens for both the House and the Senate. The House has a very structured debate process with each member only having a few minutes to speak whereas the Senate has a very open debate process with unlimited time to speak on most bills. House members are also limited in the number and kind of amendments they can make to bills whereas Senators can introduce any amendment to bills they want. 
• Senators can filibuster bills which delay any bill they want by refusing to stand down. A filibuster can only be broken by a Supermajority of 60 senators voting to invoke cloture, or the cession of debate on the bill, which forces the bill to be voted on. Once the bill is voted on, a simple majority passes the bill.

Ultimately, a bill must pass both houses of Congress before it reaches the President. Upon receiving the bill the President can sign the bill into law or can decide to veto it and send it back to Congress.

This simplified process shows the complexity that goes into passing legislation in the United States government.  It is the 5^th point which made the Georgia run-off elections so critical for the shaping of the government but it is also a point that gets largely overlooked by the public because of the filibuster.  Even though the Democrats have control of Congress and the Presidency, they will still have major constraints on passing legislation without a supermajority in the Senate.  Republicans can simply filibuster the legislation they do not agree with and that will halt the passing of a large percentage of the policy preferences that Democrats have.  The potential wrench in this process is the possibility of Democrats voting to remove the filibuster altogether which is something they have hinted towards in the recent past.  If Democrats remove the filibuster, then it would be equivalent to them having a supermajority on every vote which would allow them to pass legislation with relative ease.  However, this would be a controversial move considering it would remove one of the major checks to simple majority rule within the government.

Assuming the filibuster is kept the way it currently is, Democrats will have one shot to pass major legislation through a process called Budget Reconciliation which is not subject to a filibuster.  According to David Reich and Richard Kogan from the Center on Budget and Policy Priorities, “Reconciliation allows for expedited consideration of certain tax, spending, and debt limit legislation.  On the spending side, reconciliation can used to address “mandatory” or entitlement spending – that is, programs such as Medicare, Medicaid, federal civilian and military retirement, SNAP, and farm programs – but not Social Security.”  This means that without a supermajority in the Senate, Democrats will be constrained to passing legislation that is intrinsically tied to the budget and the amount of times budget reconciliation happens per year.  According to Dylan Matthews at Vox, “Democrats could do two bills this year, one for 2021 and one for 2022.” 

Another constrain that is tied to budget reconciliation is the Byrd Rule.  According to David Reich and Richard Kogan from the Center on Budget and Policy Priorities, “The Byrd Rule allows senators to block provisions of reconciliation bills that are “extraneous” to reconciliation’s basic purpose of implementing budget changes.  Without such a rule, committees receiving reconciliation directives would be free to add a wide range of unrelated provisions to their legislative recommendations, including provisions that might have difficulty passing under normal procedures.”  This rule is the main constraint that makes budget reconciliation distinctly different than normal legislative procedures. 

Now that we understand the preferences and constraints, here are the policy preferences that have the highest chance of being passed into law during the two budget reconciliation processes.

Highest Chance of Passing through Budget Reconciliation (According to HKlaw.com):

• COVID-19 Stimulus
• Tax Increases
• Spending to Fight Climate Change
• Healthcare Reform
• Infrastructure Spending

Lowest Chance of Passing through Budget Reconciliation: (According to HKlaw.com):

• Police Reform
• Gun Control
• Minimum Wage

The legislative process is convoluted which can make it difficult to build a proper framework to analyze potential political outcomes.  Understanding the policy preferences and constraints of politicians can be a valuable framework to filter the political sphere which can allow investors separate the signal from the noise.  Ultimately, investors who find the signal to analyze are allowing themselves to fish in a pond whereas investors who analyze the noise are stuck fishing in the desert.

Conclusion:

Here at K2 Financial Partners, our main mission is to help you reach your financial goals. We understand that the financial markets are an ever-changing adaptive marketplace and that is only exacerbated during a time when the political noise gets turned up. This is why it is important to have a well-diversified portfolio and CONTACT your advisor when you have questions, comments, or concerns.  At the end of the day, we are here to help you! 

SOURCES:

Breaking down the $900B stimulus package and $1.4T omnibus bill - POLITICO

New coronavirus stimulus package contains some big tax items | Accounting Today

https://www.whitehouse.gov/about-the-white-house/the-legislative-branch/#:~:text=The%20House%20has%20several%20powers,of%20an%20electoral%20college%20tie.&text=The%20Senate%20has%20the%20sole,consent%2C%20and%20to%20ratify%20treaties.

https://www.theatlantic.com/politics/archive/2021/01/democrats-take-senate-majority/617562/

https://www.cbpp.org/research/federal-budget/introduction-to-budget-reconciliation

https://joebiden.com/joes-vision/

https://www.hklaw.com/en/insights/publications/2021/01/senate-elections-make-budget-reconciliation-a-potential-tool

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Lincoln Investment.  The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. Past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.  Diversification does not guarantee a profit or protect against a loss.  None of the information in this document should be considered as tax advice.  You should consult your tax professional for information concerning your individual situation.

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