My F&M

Market Update: Turning the Page to Fall

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“Around and around the house the leaves fall thick - but never fast, for they come circling down with a dead lightness that is sombre and slow.”
― Charles Dickens, Bleak House

Mild eruption of market volatility in the last week of September aside, the market’s mood this year has mostly been far from somber, even as we enter that season when “the leaves fall thick”.

The last comment here as of 6/30 noted seven-day average new cases of COVID-19 had then declined 73% in the prior three months and 95% from their January peak.  A rapidly receding virus coupled with a large jump in inflation in June led us then to expect a shift in markets going forward toward more concern about inflation developments and less about the virus. 

What a difference three months can make – particularly for an unpredictable virus.  From the end of June to the end of August, the 7-day average for new cases of COVID-19 in the US reversed and surged nearly 13-fold - from 12.5K per day to 173.5K per day - as the Delta Variant became dominant and proved to be both more transmissible than earlier forms and more resistant to vaccines developed from the original iteration of the virus.  But in country after country, this pandemic has operated in waves, with large declines following large surges.  Fortunately, the end of August has marked the peak in this Delta surge for us so far and average new cases as of September 30 have declined to under 115K/day – nearly 35% lower than the August 31 high.

For the virus going forward, beyond the recent turndown in new cases, there are several other positive developments:  A very new treatment from Merck appears likely to receive emergency FDA approval relatively soon.  Americans continue to get vaccinated – more than 83% of those 65 and older have had two vaccine doses now, and 7.4% of those have already received the third shot booster.  New vaccines are in development to better address the Delta variant.  Absent the arrival of a new and more disrupting variant (hardly a given), the future is looking better on the virus front.

As to inflation, after a 5% annual increase in the CPI in June, annual inflation remained over 5% in July, August, and September, though there was a slight and perhaps over-heralded moderation in the latest reading.  Stocks largely shrugged off both the COVID surge and higher inflation, and in a strange move, bond rates initially fell as inflation spiked.  The 10-year Treasury yield has since risen back to about where it stood in June when annual CPI inflation reached 5%.  However, that yield remains significantly less than current inflation – evidence of the bond market’s opinion that this inflation episode will be transient.  This implies “sticky” inflation is not built into market expectations, and if that were to occur, could provoke volatility in markets.

While high inflation persists, many other concerns have also appeared: Congress is trying to move toward materially higher taxes, the debt ceiling and a potential Treasury default loom possibly as early as 10/18, the August news on employment growth was very disappointing, and Afghanistan undermined confidence.  Moreover, China has grabbed lots of market attention with a sharp slowdown in economic growth, significant weakness in Chinese real estate and stocks, Xi Jinping’s sweeping new push for “common prosperity”, and ponderous solvency concerns about giant Chinese real estate developer Evergrande.  If all that weren’t enough, the Federal Reserve shifted its guidance to talk of cutting back its massive monthly bond purchases soon (“tapering”).  All these headwinds swirled in just the third quarter – it’s enough to make a stout heart fear.  But apparently, it wasn’t enough to spook markets very much, which powered through with barely more than a 5% correction for stocks in the quarter (first in nearly a year).  The S&P 500 Index was down nearly 5% in the month of September, but the blended stock index total return (US and international stocks) was down just over 4% in September, was down less than 1% for the third quarter, and remains up more than 12% year to date.  It seems that as long as Federal Reserve policy remains relatively accommodative (if somewhat less so than recently) the market’s mood in the near term can handle lots of otherwise bad news and assume all is well even if there are bouts of volatility.

With respect to market mood, try to recall how you and other market participants felt about markets in March of 2020 when COVID lockdowns were first instituted, and stocks went into free-fall.  We each experienced then the S&P 500’s fastest ever decline of 20% from an all-time high.  And that was not the worst of it: from February 29, 2020 through March 23, the S&P 500 Index fell 34% in less than a month.

Given the level of broad concern about markets in March of 2020, it is remarkable and entirely unexpected that from the March 23 low in 2020 to September 30 of this year, the S&P 500 Index nearly doubled being up about 95% over that time!  That’s astounding!  All this year, but especially in the third quarter, when we’ve met with clients, the most common reaction is head-shaking disbelief at the remarkable growth in portfolios.

That is clearly an unusually large return for 18-months.  To give some perspective on just how rare that is, consider: in price returns for the S&P 500 index using month-end data for the last 35 years to calculate all 423 overlapping 18-month periods, the one in that set with the greatest gain was 3/31/2020 to 9/30/2021, the most recent one.  Moreover, it was better than the one in second place by more than 11%. 

We are as thrilled and incredulous as any about these developments, but we must also sound a more somber note.  In bear markets we regularly remind clients to pay more attention to portfolio income generated and less to market values.  Portfolio income is real, it reflects dividends and bond coupons paid out of real economic activity like earnings.  Market values, on the other hand, are more ephemeral, reflecting collective mood that from time to time, gets temporarily disconnected from reality.  This perspective is valuable in bearish environments when market values have declined rapidly, and it is equally useful in the opposite circumstance, when markets have rapidly advanced.  So, as you are pleased with unprecedented values of your portfolio, values undreamed of a mere eighteen months ago, we would ask: How has your portfolio income grown over the same time?  Generally, the answer is “a little”, single digits.  All income growth is welcome, and we don’t wish to denigrate this, but your portfolio income has clearly not kept pace with your portfolio market value in the past eighteen months.  That should give some sobering pause.  Benjamin Graham said it better: “The true investor... will do better if he forgets about the stock market and pays attention to his dividend returns and to the operation results of his companies.”

Portfolio values have grown so much partly because of the bounce back recovery from the bear market early last year.  But advances beyond that are largely because of monetary and fiscal policy: to address the economic slump caused by COVID shutdowns, the federal government borrowed and appropriated (and mostly distributed to local governments, businesses, and households) over $5 Trillion in the last eighteen months (more than $43K per household!) while the Federal Reserve injected nearly $5 Trillion into the money supply (M2), largely through its program of buying $120 Billion of bonds monthly.

The Fed will not be able to remain so relatively easy if inflation gets entrenched.  So far, inflation has significantly spiked up, but when it jumped, bond markets shrugged off the inflation scare as nothing but a temporary blip, as noted above.

Here we must consider: What if inflation proves longer lasting?  What if widespread supply chain issues and worker shortage induced wage growth turn into more persistent inflation?  Moreover, the “shelter” component accounts for about one third of the CPI and is composed primarily of apartment rents and of “owner equivalent rents” which are a function of home prices.  You have seen what has happened to home prices, and the latest we’ve seen on national apartment rents is an annual increase of about 8%.  These impact the CPI with some lags and could be another source of persistent inflation at least for a time.

If higher inflation is not transient, the Fed will be unable to remain accommodative and markets would likely retrench.  We don’t know how this will play out, but we recognize danger to markets from inflation that may be stickier than markets currently expect, and this may not be sufficiently appreciated.

Additionally, stock markets are expensive, which is to say, prices are at unusually high multiples of earnings.  Higher wage costs, higher corporate taxes, higher transportation costs, higher raw materials costs, and/or greater borrowing costs could squeeze earnings.  Sales may be hurt because of supply chain induced outages.  Higher interest rates and higher inflation could also compress elevated valuation multiples.  Lower valuation multiples, lower sales, and/or higher costs could each temporarily weigh on stock prices.  That said, seasonality for stocks is positive for the rest of the year after the first three weeks or so of of October are behind us while interest rates are still very low, and earnings growth has been exceptionally strong with more re-opening demand still expected eventually. 

In sum, conditions remain positive for markets, but it’s a fragile positive, and inflation appears to be the thing with the best chance of upsetting things.  The world is awash in created money that has bid up stock and home prices.  That’s nice, of course, but underlying, intrinsic values have not risen as much and inflation may test that, particularly if it forces the Fed to a tight money mode.  This, of course, is not a forecast, just a nod to somber reality we should keep in mind.

Long-term, stocks move up.  But in the short- to medium-term, stocks move both up and down.