While presidential elections often create tension and leave many feeling on edge, the stock market didn’t share this level of apprehension. Remarkably, October was one of the least volatile months in history leading up to a presidential election. Although this might seem surprising, it’s not entirely unusual. Markets frequently display greater resilience than we might expect. However, it’s important to remember that volatility isn’t always synonymous with selloffs or down days. As Morningstar Wealth Chief Multi-Asset Strategist Dom Pappalardo recently explained during his podcast appearance on Simple, but Not Easy, market activity post-election highlights the varied forms volatility can take. In his role, Pappalardo focuses on helping clients understand how Morningstar's research efforts translate into actionable portfolio management decisions.
(Stay tuned for additional important disclosure information at the end of this episode.)
Nicholas VanDerSchie: Many investors often try to anticipate and avoid the next big market scare. This year, the presidential election was widely viewed as the next scary thing for several months. But a funny truth about markets, they're often more resilient than they get credit for. From a purely market perspective, the election came and went with barely a ripple. October was one of the least volatile months on record for an election year, with only one trading day that saw 1% decline in the month leading up to the election.
Today we're excited to welcome Dom Pappalardo, Morningstar's Chief Multi-Asset Strategist, who will provide context on what unfolded before and after the election, and share valuable lessons to help us prepare for what lies ahead.
At Morningstar, we take pride in maintaining the long-term perspective, rather than fixating on short-term events. However, we also understand that achieving meaningful long-term investment outcomes requires navigating through periods of short-term turbulence. Let's dive in and explore how investors can remain resilient in an ever-changing market environment.
Before we get into the conversation, if you'd like to know more about how we support advisors, we welcome you to email us at simple@morningstar.com or me directly at Nicholas.VanDerSchie@morningstar.com.
Now, let's get started. Dom, welcome to Simple But Not Easy.
Dominic Pappalardo: Thanks for having me. Really excited to be here with you.
VanDerSchie: Yes, great to have you on the podcast. Maybe before we jump in, can you share with our listeners how long you've been with Morningstar? And I also heard you stepped into a new role recently. Can you tell us about that?
Pappalardo: Sure, yes. So, I've been at Morningstar for about 4.5 years, which, if you go through the timeline, means I joined during peak COVID, which was quite an experience. We could have a separate podcast about that one day. But yes, recently I took on the role of Chief Multi-Asset Strategist for the investment team. That means I sit between research and portfolio management. And really, I'm trying to help craft the narrative around connecting our research efforts to the portfolio management decisions we're making.
In addition to that, there's an external facing piece where I'm working with the media trying to drive visibility and engagement for the tremendous work the teams are performing.
Prior to taking on this role, I was previously a Senior PM & Head of the Institutional Solutions Group. That's where we ran customized mandates for large clients, mostly financial platforms. And before that, I spent about 20 years in Fixed Income Portfolio Management before I came over to Morningstar.
VanDerSchie: Okay, great. So, we're recording this episode two days before Thanksgiving. And by the time it airs, obviously, Thanksgiving will have already passed. However, I still want to know your prediction on the upcoming Bears-Lions matchup.
Pappalardo: Well, Nick, as a lifelong Chicago resident, this is a little sensitive for me. Right now, the Bears are the lowest scoring team in the league, and the Lions are the highest. So, it doesn't take a great analyst to predict that outcome. Honestly, I think the Bears would benefit from the league instituting a slogger rule prior to the contest.
VanDerSchie: Fair enough.They've had some pretty egregious losses this season.
Great. Well, let's get into the conversation. And I want to start by talking about the time leading up to the election and how the market was reacting. And one of the major details that was really striking, frankly, was the lack of volatility in the days leading up. In fact, October only had a single down day of greater than 1%. So, is that normal?
Pappalardo: Yeah, it's probably a little unusual. But I do think it's noteworthy. Look at the month of October, the total return for the S&P 500 was down about 1%, it was negative 94 basis points. And that's only one of two negative calendar months for 2024, April was the other. So, maybe it wasn't extreme day to day volatility, but the downward performance in October definitely broke the trend of positive monthly returns we've seen for most of 2024. And it's pretty safe to assume that was driven by some uncertainty around the election outcome.
Nick, it's also noteworthy that volatility comes in many forms. It isn't always just sell-offs or downward price action. I would contend the volatility post-election with the violent rally we saw is another form of volatility. And you can imagine if the tremendous pain that would have caused if an investor had been overly fearful and de-risked their portfolio prior to the election day.
VanDerSchie: So, I heard a recent story from venture capitalist, Brad Gerstner talking about a meeting he had with Warren Buffett where he asked him what else he could have done to improve investment performance over his entire career. Buffett responded that he would have slept more and gone into the office less. And so, Dom, I guess, is there any better advice than that? Or is it easier to say that when you're a billionaire?
Pappalardo: Nick, generally, Mr. Buffett's advice is worth following. His track record certainly speaks for itself. But I believe the takeaway from this quote really aligns with our investment philosophy of taking a long-term view. I interpret this Buffett quote as him advising against being overly obsessed with the day-to-day or hour-to-hour market moves as nobody can consistently call those accurately no matter how much time they spend in the office.
VanDerSchie: Fair enough. So, we're going to be intentionally light on the political aspects of the election itself because there are, I'm sure, dozens of better podcasts if that's what you're looking for. But I did want to ask you about prediction markets, which did play an outsized role in this election cycle and have received quite a bit of attention. First of all, for our listeners, can you define prediction markets? And secondly, are these something that you're paying attention to now?
Pappalardo: Sure. Yes, I did follow them, Nick, leading up to the election. I was most closely watching Polymarket, which is effectively an exchange to trade futures contracts on outcomes of things like the election. The way it works is the winging outcome allows the contract to pay off at a dollar. So, if it's trading at $0.70, it's an implied 70% probability that that will be the winging outcome.
I didn't really start watching them until about a week before the election, I just didn't believe they would be very reliable too far in advance. I did find the biggest value in watching them was on the swing states though. I felt the margin of victory in the swing states would be a key indicator for the overall outcome, and that definitely played out.
In addition to that, the swing states, particularly on the East Coast were coming in a little earlier in the evening before the overall election was called, so I thought getting that information a bit sooner also added value. And as you kind of saw the outcomes of the swing states line up and Trump's margin of victory pretty consistent across them, it was relatively obvious which way the overall outcome would lean.
VanDerSchie: Yeah, interesting. So, the prediction markets were right. Kalshi, one of the larger prediction market firms based out of New York was hours ahead of the mainstream media on election night. Dom, do you see these as useful indicators. And over a longer period of time, should we start to respect them more?
Pappalardo: Nick, elections are notoriously hard events to predict, leading up to it. My view is any sources of data can be helpful in a situation like that. It's certainly important not to view them as fact, but they are another observable data point that moves in real time, which is valuable.
VanDerSchie: Got it. So, at this stage, it's a sample size of one?
Pappalardo: Absolutely. And certainly, that could discount the value going forward, but they do feel a bit more accurate than polling does. And there's much more noise in the polling process. And with something like Polymarket, the market is the market. And again, I'll reiterate the real time updating is an efficiency polls just can't achieve.
VanDerSchie: Fair enough. So, I do want to get into the post-election reaction, both on the stock side and from an interest rate perspective. Starting with stocks, something like 25% of the S&P 500 made new all-time highs the day after the election. And that's the most we've seen since the mania of 2020. Bitcoin also experienced wild gains the following day. So, what was the market so excited about?
Pappalardo: I think the overarching theme was certainty. The fact that the outcome of the election was quick and clear and uncontested, remove kind of that tail risk of some unforeseen outcomes. I think that was the first catalyst for equity and risk markets to rally across the globe.
Secondly, it's widely believed that the corporate tax cuts that Trump implemented in his first term that are set to expire will likely be extended now. And just at a very high level, that's obviously constructive for corporate profits kind of across the board. Additionally, Republicans have historically been more lenient on regulation and permitting of merger and acquisition activity, which again are constructive to stock prices.
VanDerSchie: I want to dig into a couple areas. First, banks have been a sleepy asset class for long time. And some saw some pretty wild moves, especially the regional banks, which were up a lot. What's driving that?
Pappalardo: Yeah, banks are one of the asset classes that should benefit the most from Republican control. They have at least the twofold benefit. Number one is that chance for deregulation that I alluded to a moment ago. For banks that really translates into lower requirements of capital they have to hold against their loans and investments. So, effectively they could leverage their existing capital more and theoretically generate outsized profits because of that. And secondly, higher interest rates in a steepening yield curve are a likely outcome of Republican control and we'll dive into that a bit further. But really, as inflation concerns, perhaps resurface or interest rates move higher, banks benefit from that because their business model is such that they loan at short-term interest rates – I'm sorry, they borrow at short-term interest rates and loan at longer term interest rates, and they capture a larger spread, which goes straight to profits as the yield curve steepens and rates move up. So, banks really are well-positioned to have some fundamental improvement over the next four years.
VanDerSchie: Okay, so banks, especially those regional banks looking good. What about small caps?
Pappalardo: Yeah, small caps are somewhat similar to banks. They were one of the asset classes that had the strongest positive reaction. They also benefit from decreased regulation, more lenient merger and acquisition approval and certainly lower corporate taxes.
One downside for banks that people haven't been talking about too much, and it's not going to offset the positives, but higher interest rates are generally a substantial headwind for small caps as a log of their debt tends to be floating rate in nature as opposed to large caps which lock-in fixed rate for the long-term. So, there perhaps is a bit more volatility in the funding costs coming up for small caps.
We've been overweight small caps, Nick. And not only is it supported by what we think is going to happen going forward post-election, but the valuations relative to large caps are extremely attractive. The ratio of small cap valuation to large cap is at a historically wide point right now. So, we think there's a meaningful margin of safety to maintain and perhaps even increase that overweight going forward.
VanDerSchie: Excellent. So, we've touched on stocks. Let's move to interest rates and bond yields spiked immediately following the election, even as the Fed has been cutting rates. Why aren't the yields falling as expected?
Pappalardo: Yeah, there's several factors influencing that. The main factors are, as I just mentioned, resurfacing concerns around inflation, consistently strong economic data and low unemployment. Those three factors point to the fact that the Fed doesn't need to cut interest rates aggressively right now. And of course, we saw a 50 basis point cut in September and another 25 in November. And I would say that the short end of the yield curve did track with that. But the Fed doesn't control longer term rates, and longer term rates are where we've seen increases post-election.
And it's generally believed that the market controls the long end of the yield curve, while the Fed controls the short end of the yield curve. So, you've seen some divergence there.
VanDerSchie: Yeah, it makes sense. So, I guess as a quick follow-up, what do rising yields potentially indicate as it relates to inflation?
Pappalardo: Yeah, it means that people don't necessarily believe we're totally out of the woods yet. It also means that it's likely the Republican controlled government will be issuing substantial amounts of debt. And at some point, investors will require higher interest rates to continue to buy that debt at the risk level increases.
VanDerSchie: Dom, before we pivot to post-election, I'm curious to get your opinion on the biggest market overreaction in your estimation?
Pappalardo: Nick, one of the things that jumps off the page is Tesla stock. Tesla stocks up 35%, 40% post-election. And there has been no material change to their business. We don't anticipate any material change to their business. Sure, the involvement of Elon Musk into the political arena could bring some unforeseen tailwinds. But the stock wasn't exactly cheap pre-election, and now it's rallied substantially more. For a point of reference, the Morningstar current fair value is $210 a share, and today it's trading over $340 a share.
VanDerSchie: Yeah, it's a little frothy.
Pappalardo: Little bit.
VanDerSchie: Okay, let's talk about what's transpired post-election. And it's always interesting to do scenario analysis. One notable trend over the past few years is the sheer amount of money flowing into cash and money market funds. And cash assets have grown to over $7 trillion. And if you examine a chart, that growth has essentially gone vertical in recent years, while the Fed's rate hikes are the primary driver, it's probably true that there's a segment of investors that intentionally held more cash, were kind of waiting for the election to pass and then plan to reinvest that afterwards. But by the time the market opened Wednesday, following the election, those investors would have ultimately missed a significant rally. So, help us square that, Dom. What are the best portfolio management practices leading up to a major event like this?
Pappalardo: Yeah, Nick, it really comes down to discipline. And it's the discipline to adhere to whatever your investment philosophy is and really the commitment to honor the underlying principles, regardless of uncertainty. For us at Morningstar, this comes down to our long-term view, our fundamental research-driven valuation and the rigorous scenario testing we put portfolios through.
Following up on your cash comment. One of the key pieces in our 2025 outlook discusses that where cash balances have reached all-time high, and this really feels like it's a good time for investors to move off that cash pile and perhaps add longer term fixed income.
VanDerSchie: Dom, on that note, are there any specific examples you can share from Morningstar strategies?
Pappalardo: Absolutely. Nick, our advice leading up to the election was prepare, don't predict. And we certainly followed our own advice as an investment team. We worked to ensure the risks in our portfolio were balanced. And what I mean by that is we didn't want all our exposures leaning towards one outcome versus another. For example, U.S. small cap and banks were well-positioned to rally for a Republican victory, which we saw.
However, we also had an overweight in China, which we think would have benefited from a Democratic victory. The most important point here is that all three of those exposures were trading well below our fair value estimates and were attractive fundamentally to us. So, that presented a margin of safety to the downside, even if the outcome went against the thesis for owning them. So, again, comes back to the discipline of following our process, which is really that fundamental valuation component.
VanDerSchie: Makes sense. So, there's the famous John Templeton quote, markets climb a wall of worry. As you see it, does the worry exist out there right now?
Pappalardo: I believe it still exists, but it's probably shifted away from the election. The certainty around the outcome of the election really removed that level of worry from the market. Certain issues like tariffs and inflation still have unanswered questions around them, but they're being more than offset by the positive expectations around the business-friendly policies that we discussed earlier.
VanDerSchie: Okay. So, the market appears to be in a relatively good spot for the time being, but as you point out, the future is always uncertain and tariffs, or the potential of them are creating some angst as a catalyst for more inflation. If more tariffs are coming, what is your sense around the timing and impact?
Pappalardo: Yeah, they probably are coming, Nick. The timing is a little unclear at this point. It sounds like President-elect Trump will be aggressive in trying to push them through as quickly as he can. It's difficult to digest what that means though, because policy still has to be implemented, then it has to be enforced, and then it starts to flow through things like corporate earnings and inflation prints. So, there is some lag from policy to changes in market data or economic data. Most definitely markets will lead that, but in terms of judging the actual impact, it's a bit difficult to predict.
VanDerSchie: And I guess bringing it back to a portfolio management perspective, how should advisors be thinking about this with their clients and maybe how are you and the team preparing as it relates to the Morningstar portfolios?
Pappalardo: Yeah, we've had to adjust our research inputs and assumptions. I mentioned the concept of scenario analysis before, and what that means in our view is we have a base case where we expect a range of outcomes to be most likely. However, there's tail risk on either side of that to the positive or the negative. And we've really had to spend a bit more time focusing on those extremes, the tail risk events. And as we do that, we're trying to model out the more unlikely or more impactful outcomes that could potentially materialize. And again, we don't allow those to change our base case, but we do consider them in the possible range of outcomes in our scenario analysis.
VanDerSchie: That makes good sense. So, we're here in Chicago and even more broadly in the U.S., the top selling beer is Modelo. And as most of our listeners are probably familiar, Modelo is made in Mexico. Should our beer drinking audience be prepared for higher prices here?
Pappalardo: Nick, it's good timing for this question. Just yesterday, Trump actually listed Mexico as one of the targets for a specific outsized tariff increase. 25% was a number that was thrown out. Unfortunately, that means price increases on products like Modelo are quite possible. However, it's important to think through the math a little bit. Remember that tariffs are only applied to the cost of the imported good, not the final retail price. I'm not an expert on the importing of beer, but let's assume a bottle of Modelo costs the importer $0.40, add the 25% tariff, it's now $0.50. That translates to $1.20 higher for a 12 pack. So, sure, in that scenario, the price went up, but it may not be nearly as much as some customers may expect when they see the 25% tariff headline.
VanDerSchie: That makes sense. So, no drastic impact to the price of beer in Chicago, at least for now. We'll see. Okay, so much of our conversation emphasized the lead up and then the immediate reaction to the election. And we're sitting here now in late November, a few weeks have passed. And it's interesting because we clearly saw the market impact and that response in the days after the election. But Dom, what can we infer from that? Was the market pricing in the new long-term information that was just becoming known? And sitting here today, how would you score that? Are things settling back down?
Pappalardo: Yeah, it's a fair question, Nick. I've written that I believe the immediate response to the election in some ways reset the baseline for some markets. To me, that was a one-time event. We may still be going through that adjustment period as new information is being digested, but we'll quickly revert back to traditional market fundamentals like corporate earnings, interest rate policy and macroeconomic data as the main drivers of future price movements. Generally, the trends that began on the Wednesday after the election have continued. And therefore, our views really haven't changed meaningfully at this point. We still believe domestically that U.S. small caps and banks offer value, while our China allocation is still appealing internationally despite the concerns around new tariffs.
VanDerSchie: If we take a big step back and think about elections historically, how important are they to stock market outcome?
Pappalardo: Historically, starting valuations matter much more to long-term returns than who the party in charge is. The current regime could deviate from that slightly as Republicans will control the White House and all of Congress suggesting more policy changes than usual may occur. But really, if you do any type of back testing, both parties have shown tremendous upside to the stock market over the long-term. And again, we really believe the starting valuation, which by the way, were a bit stretched coming into this election are really the determinant of long-run performance.
VanDerSchie: Got it. So, the last thing I'll ask you about is say, you were an advisor, coaching clients, the presidential election obviously was a big weight on markets, it loomed large. There won't be another election now for four years and there will be countless events that hang over markets between now and then. So, I guess, what strategies or principles would you place the most emphasis on to manage through whatever comes at us?
Pappalardo: Yeah, no doubt, Nick. I agree with that completely. The election was unknown unknown. I can guarantee as you just alluded to, markets will experience unknown unknowns over the next four years, which by definition are unpredictable. When those inevitable periods of uncertainty materialize factors like diversification, fundamental analysis, and valuations matter most, these are really the cornerstones of our investment philosophy and the things we come back to and in many ways simply bring us back to that long-term view we've talked about throughout this conversation.
VanDerSchie: Fantastic. All right. As we do on Simple But Not Easy, we want to leave our listeners with a 10-second takeaway. If you want to give them one thing to take away from this conversation, what would that be, Dom?
Pappalardo: Nick, I would say that adhering to your discipline matters most, and I think this was a great example of that. And as we build robust, thoughtful portfolios, we really believe you could still find values of opportunity despite stretched valuations, despite the uncertainties around political regime changes, not to mention the Fed regime change of lowering interest rates. But again, being disciplined in times like this is really the most important factor.
VanDerSchie: And there you have it, another episode of Simple But Not Easy. As always, we're grateful to Dom for spending time with us today. And once again, if you'd like to know more about how Morningstar can support you, please drop us a note at simple@morningstar.com or me directly at Nicholas.VanDerSchie@morningstar.com.
That wraps up this week's episode. Before we depart, if you enjoy hearing the insights on the podcast, please consider leaving us a five-star review on Apple Podcasts or Spotify. It'll help others find us. Until next time, thanks for listening.
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