While it is technically true that the S&P 500 stock index added 0.58%[i] in the third quarter, it really didn’t feel that way. Small cap U.S. stocks declined, midcap U.S. stocks declined, and foreign stocks declined – both developed and emerging markets. Seven of the largest ten stocks in the U.S. advanced, led by Alphabet, Tesla, and Microsoft, which was enough to turn the major index positive despite most stocks losing ground. For most companies and countries, however, the big news on the quarter was the surge in inflation caused by significant supply disruption, both of goods and of services. The world continues to emerge from the Covid crisis, but mostly in fits and starts. The global economy that is emerging seems to be profoundly different than the one we had before. That said, the Federal Reserve has maintained a very accommodative monetary policy, so enough liquidity exists to allow the market to “tread water” more or less. Inflation may be rising, but companies seem to be able to pass on their higher costs because their customers are in better financial shape. That means corporate profit margins can remain at or near all time highs. Whether one believes Fed policy has been wise or not, this is not the environment in which one should expect a major decline.
The first two months of the third quarter were marked by a concern that the economy was slowing. Utilities, real estate, and communications, three of the most defensive sectors, performed the best while those that are the most economically sensitive – energy, materials, and industrials – lagged[ii]. September saw a surge in energy prices amid a pickup in the economy, so the roles reversed. Financial services stocks had the best quarter of all in that very low interest rates promote the “game-ification” of financial markets. With IPOs, mergers, and other financial activities at record levels, there were nice fees for Morgan Stanley, Goldman Sachs, and their peers.
Emerging markets drew most of the attention this past quarter. Everybody was trying to determine whether China was still a reasonable place to invest with all the new regulations imposed by Xi Jinping. China’s -13.34%[iii] quarterly return dragged the MSCI All Emerging Markets index to a -8.09% loss. International stocks as a whole were only down -3.02%, because Japan gained 4.56% and Europe and Canada were only modestly lower. The best performing international stocks last quarter were actually in what are known as frontier markets. This encompasses countries in Asia, Africa, South America, and eastern Europe that do not qualify for EM status. Think places like Columbia, Nigeria, Qatar, Austria, and Vietnam.
Bonds were about unchanged last quarter. Yields are very low, but until recently they have been relatively stable. Low prospective returns have led many investors to take the extra risk of high yield corporate, floating rate, high yield municipal, or emerging market debt in order to earn higher income. In all cases but the latter, it paid off during the third quarter. With interest rates rising this quarter, taking that extra credit risk may pay off again this quarter. The risk in doing so is a sudden economic downturn which increases fears of default, but I just don’t see that happening in the near term.
Because the biggest concern this quarter was emerging markets (China most specifically), that was the area we spent the most time on. We reduced exposure to China either by trimming the overall emerging market weighting or by exchanging to an emerging market fund with a lower percentage of Chinese stocks. One didn’t want to avoid emerging markets altogether, because some countries (India, for example) performed quite well. We also had to address rising inflation and its impact on the bond market. The largest moves were in shorter duration bonds. Short term bond yields are so low that even fairly small interest rate increases can cancel out all the income one receives. We’ve been replacing some of our bond exposure with lower risk securities with less interest rate sensitivity, such as market neutral and convertible arbitrage funds. We’ve also been adding a small amount of commodity exposure to many portfolios. Lastly, we continued to reduce exposure in some of the areas that made us a lot of money in 2020 but have spent most of this year working off over-valuation. Funds (ETFs) focusing on genomics, clean energy, and emerging technologies have struggled this year, so we have reduced our exposure to these more narrowly focused areas.
The stock market’s -4.65%[iv] decline in September spooked a few people, but we expected a pullback due to the frenetic pace of new highs throughout the summer and the fact that the September to mid-October period tends to be a seasonally weak time for stocks. Fortunately, this October has gotten off to a good start. Increasingly, the market volatility that one associates with October actually occurs in September, so once we get to the start of earnings season in mid-October, we are usually “out of the woods” so to speak. We can’t predict exactly when the market will get over its September funk in any given year, so we tend to avoid seasonal trading. That said, we were not at all surprised when stocks made new all-time highs on October 21st.
We believe that earnings season will continue to provide a boost to most stocks as corporate profit margins remain at or near record levels. The next period of caution will arrive right before the Federal Reserve meeting on November 2-3. The Fed is expected to announce a modest tapering in bond purchases, which would remove some of the very ample liquidity from the market. An announcement of a greater than expected tapering would almost certainly adversely affect both stocks and bonds, but Chairman Powell seems keen not to roil the markets the way he did in late 2018.
Commentary – It’s What You Know For Sure That Just Ain’t So
Mark Twain had a number of wonderful and witty sayings. “Kindness is a language which the deaf can hear and the blind can see”, and “God created war so that Americans would learn geography” are two of my favorites. His quote, “It ain’t what you don’t know that gets you into trouble, it’s what you know for sure that just ain’t so” is probably the one with most relevance to investors. Twain seems to have understood overconfidence bias some 80 years before Daniel Kahneman and Amos Tversky won a Nobel Prize for analyzing people’s behavioral biases. In the thirty-five years since I started in the financial services industry (yes, in 1986) nothing has cost people more money than the attempt to sidestep market declines because they just knew that the market was about to go down.
I am not saying that timing the market is impossible because that is obviously not true – those who try are occasionally successful. Great market calls are so rare though that we tend to remember the names of the very few who made them. Jesse Livermore, Elaine Garzarelli, and Michael Burry come to mind. I am instead saying that market timing is a low probability exercise. Selecting both a favorable time to exit and then an auspicious time to re-enter the market is very difficult. Despite more than a century of attempts, nobody has found an indicator robust enough not to give false signals timely enough to warn you before the market is already down more than 10%. Professionals talk about “batting average” because they know NOBODY gets every trade right. Non-professionals often believe that there are those who get all the big moves right, because the advertisements on the internet tell them so.
One of the worst mistakes non-professionals make is believing that the fate of markets lies with who is in the White House. The fact of the matter is that stock performance depends primarily on corporate profits (both current and expected), the future rate of inflation (because inflation reduces the value of a dollar earned in the future), and the amount of liquidity provided by the Federal Reserve that companies, investors, and speculators may use to leverage up their return. For example, Apple Inc. generates billions of dollars in free cash flow every quarter. It does not need to borrow money in the bond market to fund its operations, but it does so anyway in order to buy back some of its shares. This increases the reported earnings per share because Apple’s growth rate is higher than it’s cost of borrowing. If the Fed holds borrowing costs low enough, even very mediocre companies with much lower returns on capital can take advantage of this form of arbitrage. That is what we are seeing today. It’s gone on since the Great Financial Crisis, and it has largely contributed to the twelve-year bull market that began in March 2009. Presidents do not control how much liquidity is in the economy, at least not directly, therefore they tend to get too much credit or blame for stock market movements. Companies focus on serving their customers and growing their businesses, regardless of who is in the White House. No particular policy of the Biden administration, the Trump administration, or the Obama administration before that was the catalyst responsible for the bull market.
There is an old saying on Wall Street – “the trend is your friend until the bend at the end”. This is a clever way of saying that all trends, including this one, will eventually end, but the smart money respects it and doesn’t constantly try to “front run” the ending. Bull markets do not end because prices get too high, rather they die because the fuel that propelled them to the high prices has been exhausted. Leverage is wonderful on the way up but disastrous on the way down. Knowing this forces us to carefully watch liquidity conditions, inflation, and corporate profit margins to get a hint at when we might shift to a more defensive posture. Not because we think we can avoid the next market crash, but that we may be less exposed when one does come[v].
Mark Twain also wrote: “October: This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August, and February”. Humor aside, every day we think hard about what might go wrong and how this bull market may end. Stocks are by almost every measure quite expensive, inflation appears to be on the rise, and at some point the Federal Reserve will not be able to be this accommodative. That said, the bull market has overcome many challenges over the past several years and has therefore earned the benefit of the doubt. That is we try very hard not to let our concerns cause us to give up a meaningful amount of return potential.
[i] S&P 500 performance from Standard & Poor’s via Morningstar
[ii] Sector performance information via JPMorgan
[iii] Foreign stock performance from MSCI International (Morgan Stanley), via Morningstar
[iv] S&P 500 return, again courtesy of Standard and Poor’s.
[v] One thing I’ve learned is that all large market declines start out as little market declines, but the vast majority of little market declines do not turn into crashes. Crashes happen when the initial problem is not handled right. You can’t predict policy errors or market panic in advance.
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