Stocks maintained their strong advance in 2021 by adding another 8.55%[i] last quarter. Technology, Energy, and Real Estate led the way. Economically, that makes little sense – technology, as a long-dated asset, should benefit from disinflation while energy (a cyclical) should respond to economic strength and higher inflation. The Telecom and Utility sectors are usually viewed as defensive because people generally don’t use less electricity or phone service during a recession. Here too performance varied widely; telecoms rose 10.72% last quarter while utilities lost 0.41%. Rather than flowing in one particular direction in response to a coherent Federal Reserve policy, money in the market is sloshing around haphazardly. Attributing any given day’s results to a particular concern, such as COVID or China or inflation, is giving traders way too much credit.
Source: JPM Guide to the Markets 3Q 2021. The Fed’s balance sheet expansion lifts stocks after the Great Financial Crisis and again after the COVID Crisis
The Federal Reserve continues to pump money into the financial system by buying bonds. This is depressing yields, forcing income-seeking investors to opt for riskier securities if they do not want to settle for historically low yields. All of the Fed’s buying doesn’t do bond investors much good in the long run. A decade of central bank bond buying has all but ensured that inflation levels will exceed the yields of high quality bonds. Today, the bond market yields less than 2%[ii]. Given that inflation is currently around twice that, bond investors receive about a -2% annual return in purchasing power terms[iii]. Even without factoring in inflation, the U.S. Aggregate Bond Index has delivered a -1.60% loss through the first half of 2021. Some bond investors have migrated to riskier high yield “junk” bonds which have returned 3.62% so far this year, while others have embraced dividend paying stocks. One hopes they remember that in the last real bear market (2007-09) quality bond losses tended to be well under -10% (in fact long treasuries actual rose), while high yield bonds and dividend paying stocks each lost more than a third of their value. The market has an expression for taking large risks to obtain modest returns – picking up pennies in front of a steamroller. That pretty much sums it up.
Switching to foreign markets, foreign stocks were again rather subdued compared to the U.S. Developed foreign markets gained 5.69% and emerging markets rose 6.08%, according to S&P Dow Jones. Both indices are up less than 10% year to date. Japan has been notably weak, while Canada has strung together two straight quarters of 10% plus gains on the strength of soaring lumber and energy prices[iv]. China’s crackdown on its technology leaders has been a drag on Asian and emerging market indices because these stocks are some of the largest components.
Gold has had a rough half year so far as the dollar has been strong, but commodities in general have been having one of their best years in a decade. Energy and agricultural commodities have led the way. With inflation posting some of its strongest numbers in years, this area has become more interesting to us. We are looking at ways to hedge inflation that don’t involve gold or inflation-indexed bonds.
There was not as much trading activity this quarter, as the narrative driving both the bond and stock markets remained largely unchanged. We review portfolios on an ongoing basis to see if there are any funds or ETFs that are underperforming such that we could replace them with better performing alternatives and not expose the portfolio to greater concentration risk. At the margin we have reduced the weighting in cash and bonds and increased the percentage allocated to stocks, but we are conscious that we (and the market as a whole) have been forced to pay ever higher prices for the hope of future returns. Steamroller indeed.
There has been a very sharp correction in the more aggressive sectors of the market – cryptocurrencies and cutting-edge industries like electric vehicles, genomics, financial technologies, and cloud-based consumer technologies. We don’t have much exposure to these areas, but to the extent that we do, we are riding it out. One must expect a much higher level of volatility if one hopes for significantly greater return. Again, money moves in and out of these stocks so fast that a tactical approach (timing) just doesn’t work.
From time to time, there will be “corrections”. Volatility is a part of investing, such that if you aren’t comfortable with the occasional 5%-10% decline, perhaps you are more of a saver than an investor. That said, once a decade or so the stock market undergoes a more significant decline (30% or more) usually tied to either a sharp fall in economic output or a sharp rise in costs (inflation). Ex-post, market corrections associated with either of those causes may be correlated with an inverted yield curve or an abnormal advance-decline ratio. On the other hand, the “crashes” of March 2020 and October 1987 fall into the category of event-driven sell-offs, where one does not get much of an early warning.
Investing can be broken down into macro (asset allocation) and micro (individual security selection). Much of the macro part of investing is trying to identify those times in which the risk of a more significant decline is elevated. When those conditions are present, investors should re-assess their asset allocation. Most of the time that risks are elevated the market will undergo a modest correction but then the upward trend will promptly re-establish itself. In these cases, taking no action will have been the better strategy. The longer the market goes without a major decline, however, the more valuation and sentiment can get way out of whack and the odds of a major market event rise. Theoretically, the sharp plunge sixteen months ago should have put us in a place where we would not have to worry about excess speculation for several years. As we all know, however, speculation has come back with a vengeance. Stock prices have about doubled off their March 23rd low.
The stock market doesn’t peak because valuations reach 20 times earnings or 18 times sales or 5 times book value or any other accounting metric. Instead, markets peak when investors begin to worry that they won’t be able to find other investors to sell to at higher prices. Therefore, it is important to be able to sense when the market (or a segment of it) is approaching its saturation[v] point. As I stated above, we appear to have reached that point earlier this year with Bitcoin and other cryptocurrencies and with companies that fit the “disruptive technologies” description. Hopefully that is all the correction we will get for now, but I find it difficult to believe that we are going to get off that easy[vi]. That said, we have not yet positioned our portfolios for a more serious decline. Risk on, but watching closely.
When I started in the financial services industry in 1986, the Federal Reserve was in the process of bringing interest rates down from the mid-teens. It had been necessary to hike rates to 16% or so back in 1981 in order to crush inflation. By 1986 rates had fallen to around 10% as inflation retreated into single digits. The Fed never seemed to be able to go two straight meetings without changing the discount rate, because fears of returning inflation seemed to conflict with fears of economic slowdown. This tug of war served active investors very well – if you could correctly anticipate the Fed’s next move in time to position yourself accordingly, you could expect to make a greater-than-market-return profit. The dynamism of interest rates and the business cycle drove investment decision.
Today everything is different. The Federal Reserve is basically stuck on zero percent. There is no business cycle to speak of, because the Fed is trying (through its open market activities) to maintain a perpetual state of early-to-mid cycle. This encourages a more passive approach to investing. If you imagine a bathtub where the Fed is filling the tub while investors thrash around like a three year-old, active investing is essentially betting on which areas of the tub will see higher or lower water levels, while passive investing is betting on the overall water level. Since the 2007-09 financial crisis, a succession of Fed governors have made the latter virtually a slam dunk.
In this environment, very few major companies ever go bankrupt relative to 30 or 40 years ago because interest rates are much lower and most companies of any size have access to credit. Of course, their stock and bond prices have risen to reflect their much lower degree of economic risk. The problem is, if the Fed ever stops pumping money into the economy through the purchase of government and corporate debt, interest rates are likely to rise. This means credit won’t be as easy to obtain and more companies will fail and therefore risk premiums will have to rise. In other words, stock and high yield bond prices will fall. If you recall, the Fed tried to end this process back in October 2018 and the 4th quarter of that year was rather ugly for investors.
Why, you might ask, would the Fed ever stop pumping liquidity into the market if doing so would cause a market decline? One reason is that not everybody in an economy is an investor. Some only have the means to be a saver. Because the Fed is keeping interest rates artificially low, savers get less interest than they should. In essence, savers are subsidizing investors. This helps increase wealth inequality across classes, and history suggests that rising wealth inequality ultimately does not end well. At some point (probably during the next recession), the idea of stimulating the economy through Fed purchases is likely to become politically unpopular (the bottom 50% of the income spectrum owns such a tiny percentage of the stock market that it’s almost impossible to perceive on a line graph).
Things have changed a lot over the past 40 years. The way one reads the market and the tactics one uses to maximize return for a given level of risk have certainly changed. As a result, our methods have evolved to the use of more passive vehicles like ETFs and now, rather than anticipate the Fed’s next move, we start from the default position that the Fed is not going to change its tactics unless it absolutely must. That day will come, but it is not going to be tomorrow and it is probably not going to be for quite a while. When it comes, advisors and investors will face a new environment and new tactics will have to de devised. It is our mission to guide you through that as smoothly as we can.
[i] Per S&P Dow Jones Indices
[ii]1.97% as of Today per YCharts (Vanguard Total Market Bond ETF)
[iii]It’s even worse if you own CD’s that yield 1% or less
[iv] S&P Canada Broad Market Index Total Return in US dollars, per Morningstar Workstation
[v] Meaning that almost all potential buyers are already in.
[vi] Incidentally, I am not worried about the stock market effects of a resurgence of COVID. I do not foresee the country shutting down like it did last year. America has collectively decided that it is going to stay open and deal with the consequences.
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