Midweek Potpourri: Fund Flows, Tax Cuts and Budget Brinksmanship

This sign could be making a comeback. Photo by Chip Somodevilla/Getty Images.

While Tuesday was an extremely slow news day, as evidenced by the fact the most clicked-on story in The Wall Street Journal was a depiction of a hedge fund that is buying bunches of bonds trying to "...take advantage of the effects of supply and demand in the $12.8 trillion Treasury market,"^[i] Wednesday was chock full of stories worth noting. Here is our attempt to bring you the highlights (or lowlights-you be the judge).

People Sold Some ETFs

Equity exchange-traded funds (ETFs), widely loved for their liquidity, came under fire when circuit breakers and wild stock price swings made some funds impossible to trade or price as markets plunged on August 24. Some speculated this snafu would diminish ETFs' appeal, and with new data showing big net outflows from US stock ETFs last month, some suggest these structural flaws might bear some of the blame. In our view, though, that's a bit of a stretch. Based on our read of the daily ETF data available at ETF.com, these outflows resemble investors' typical reactions to big volatility. Folks fled stock ETFs as markets fell, then flocked back as stocks rebounded in the following days. On August 26, more than $5 billion poured into US stock ETFs. This is all fairly typical of how ETF flows usually look during pullbacks, so we rather doubt August's big net outflows represent a sea change in investors' preferences. Most likely, it's just a manifestation of swinging investor sentiment and another illustration of the fact many folks struggle to not react to volatility, a classic investing error.

A Presidential Candidate Named Bush Says Some Things About Taxes

As always, we favor no candidate or party and assess politics solely from the perspective of how legislation, regulation or plans may impact markets. We believe political ideology is blinding and dangerous for investors.

No, this headline isn't a flashback from 2000's campaign. Or 1992's! It's a reference to former Florida Governor Jeb Bush's latest pitch for the presidency-another attempt at the mythical "Grand Bargain" tax reform deal bridging the gap between the Republicans and Democrats. This is the Sasquatch of American politics and is precisely the kind of market-friendly campaign rhetoric GOP candidates tend to employ during a Presidential race, teeing up the odd phenomenon we call, "The Perverse Inverse." We'd suggest not getting overly excited by the proposed Bush Tax Cuts! Part Deux, lest you repeat history.

Bush's plan calls for a vast simplification of personal income tax brackets down to three-28% for the highest earners (down from 39.6%), 25% and a bottom rate of 10%. (The income levels where each would kick in aren't out yet.) Bush further argues corporate taxes should be cut from the current 35% rate to 20%, and the government's practice of taxing foreign-sourced profits ceased. He proposes a tax "holiday"^[ii] allowing businesses to repatriate cash held abroad with a one-time, 8.75% tax assessed over 10 years.

Those are basically core Republican principles, so you might ask: "When do we get to the Grand Bargain?" Well, Bush aims for bipartisanship by claiming he'll slash many individual and corporate tax deductions (not on charitable contributions) and end hedge fund managers' much-decried 15% tax rate by striking "carried interest"-theoretically making the aforementioned tax rates closer to individuals' and businesses' effective tax rates (the rates they actually pay after deductions are considered).

Perhaps that strikes you as grand, perhaps it strikes you as the worst thing ever. We aren't here to judge. Our point is, simply, this is the kind of pie-in-the-sky, seemingly market-friendly promise Republican candidates often make on the campaign trail. It is the primary way they garner support. And, in our experience, the American investing public leans Republican. This is why investor sentiment often swells in an election year when a Republican wins the White House, driving above-average returns. But after the inauguration, these pie-in-the-sky plans prove beyond reach and get watered down (if not outright eliminated, as campaign promises often are) leaving a disappointed electorate. As sentiment sags, so do stocks' typical returns in a Republican president's first year. (Exhibit 1)

Exhibit 1: The Perverse Inverse

Source: Global Financial Data, Inc., as of 1/7/2015. S&P 500 total returns, 1926 - 2014.

It's too early to handicap whether this or any candidate's tax reform plan has a shot at passing. Heck, it's 14 months from the election and there are so many candidates still in the race you can field an entire football team's offense and defense.[iii] But we would suggest not getting overly caught up in the campaign-trail rhetoric, no matter how great it sounds.

Is a Government Shutdown Lurking?

Bloomberg's Jonathan Bernstein argues probably not, though The Wall Street Journal's Editorial Staff seems unconvinced and The Washington Post cites "experts" as saying a shutdown is likely.

At issue: Congress hasn't passed any bills funding government in 2015, and the government's fiscal year ends September 30. Hence, come October 1, some fret the government will have to "shut down"^[iv] because Congress didn't fund its operations. Now, Congress could still come in and simply pass a short-term patch extending the current budget for a few months, allowing lawmakers time to hammer out a deal for fiscal 2016. But the WaPo's experts estimate there is "well over a 50% chance of a government shutdown."

While a deal could still happen-after all, both legislative chambers are Republican-controlled presently, which may incentivize them to make a deal, particularly while Presidential campaign season is just warming up-investors worried over the possibility of a shutdown would be well served to consider how government "shutdowns" typically impact markets. Exhibit 2 shows all government shutdowns since 1976. Of note: The last occurred in October 2013, and stocks rose during it and in the 3-, 6- and 12-month periods thereafter. History shows that even if we have a shutdown, there is little reason to fret it will smack stocks.

Exhibit 2: Historical US Government Shutdowns and Stocks

Source: FactSet, as of 9/9/2015. S&P 500 Price Returns. *Government shutdowns before 1980 were generally even less widespread than the present, as many agencies simply figured Congress never meant for them to close. Also note: The November 1981 and December 1987 shutdowns occurred over weekends, hence the 0.0% return during.