The Midway Point

If we are raising flags for the 4th of July celebration here in the U.S., that must mean we are also halfway through 2021. This year has gone super-fast, with vaccinations, a gradual return to normal life, and good market returns helping to quickly pass the weeks. What a difference a year of incredible scientific advances has made.

S&P 500, Nasdaq Composite, and Russell 1000 (large company stocks indexes) all reached new highs in 2021, while the Russell 2000 (small company stocks index) mostly treaded water — which was unsurprising in light of how far ahead small caps had advanced over the previous 12 months. Small caps roared back from their 3/18/20 trough to post a 141.0% return with the 2021 high on March 15. The Russell 2000 has made no progress since that date, declining by 1.8% from this year’s high through the end of the second quarter.

One of the most dominant trends from late 2020 and the first quarter of 2021 began to fade; namely, the outperformance of value stocks over growth stocks. This shift came as the Federal Reserve indicated in June that it may raise rates somewhat sooner than expected amid signs that inflation was beginning to take hold.

In the bond market, the headlines out of the Fed sent the yield of the 10-year note down 29 basis points to 1.45% from a recent high of 1.74% in the first quarter. A wide divergence in sector performance during the first quarter narrowed in the second, with all but the utilities sector posting gains. Energy stocks still led, gaining 12%, but technology stocks rose 11.3% after trailing all other sectors in the first quarter.

Economic and earnings data continue to show signs of growth, and recent progress on a potential infrastructure spending plan has offered some positive support. The S&P 500 finished a remarkable quarter of earnings:

• 86% of S&P 500 companies reported a positive EPS surprise and 77% reported a positive revenue surprise.
• The estimated earnings growth rate for the S&P 500 is 61%. That would be the highest reported growth rate since Q4 2009.
• Eight sectors have higher earnings growth rates today (compared to March 31) due to upward revisions to EPS estimates.
• 63 S&P 500 companies have issued positive EPS guidance.

As the economic pendulum has swung from very bad to very good, the markets remain highly focused on the Fed and the triggers that would cause them to reduce stimulus and raise interest rates. Inflation right now is the biggest trigger they’re watching. Rising prices have prompted some debate around the water cooler about what comes next — inflation, deflation, or stagflation. In simple terms, inflation brings higher prices of goods and services, deflation is the opposite, and stagflation is high inflation with slow growth and high unemployment (the least desirable of the three). The last stagflation period was the oil shock calamity of the 1970’s.

We knew that the economic recovery would cause supply chain and labor shortages as consumers and businesses returned to pre-COVID activities. The Fed and most others are hoping that current inflation spikes will be temporary, and prices will fall as capacity is added. But right now we are in the thick of it, and uncertainty is high. Lumber prices just took a ride on the meme-stock price roller coaster. Auto auction prices and some agricultural commodities could be next. Some prices like rent costs could begin to move higher while other prices are reluctant to bend lower (see oil, copper, and steel). At Bluerock, we are watching, measuring, and waiting.

With interest rates low and financial capital easy to access, one would think that capacity could be quickly added anywhere that prices remain too high for too long. In most cases, those supply/demand curves you studied in Econ101 should prevail. However, it’s been so long since many of us have witnessed higher prices that it has put watchers a bit more on edge. The equity markets don’t seem to be bothered, as they have returned to new all-time highs in a slow summer tape usually associated with beach time. Long bonds also appear relaxed, with the 10-year Treasury yield back at 1.45%. Shorter rates have floated higher, as the Fed warms up its inflation-fighting cattle prod just in case they need it. So, sit back and watch to see if higher prices are the cure for higher prices. Will Disneyland benefit from a delayed new car purchase? Will people who decide to rent versus buy dine out more?

Bluerock is often asked about how we can keep spending money as a nation without impacting the long-term creditworthiness of our fiscal position. The Federal Reserve, the U.S. government, and its counterparts all over the world are spending trillions of dollars in response to the COVID-19 crisis and borrowing trillions of dollars to do so. Here are two reasons why this spending could continue:

• Global Reserve Currency, USD Dollar: A big factor in keeping the printing machine going is the US dollar. If the US dollar maintains its status as a global currency, it will continue to be in demand, even as its value diminishes due to excessive printing.
• Savings: The world has been and still appears to be awash in savings, which is one big reason why interest rates on U.S. Treasury debt — and many foreign governments’ debts — were so low before COVID19 hit. This situation suggests that there is ample room to increase borrowing now at a relatively low cost.

Even with the markets hitting record highs, at some point all this newly-printed currency may result in a slowing of the economy, higher daily expenses, and/or a pull-back in the markets. These are only some of the reasons we remain cautious and diversify how we position our clients in the markets.

Looking ahead to the second half of 2021, we think some notable market risks are associated with the combination of peak economic/earnings growth rates, Federal Reserve policy, and some stretched investor sentiment conditions.

We also frequently make a distinction between “investment” and “speculation.” The investor seeks long-term value, while the speculator shoots for short-term profits. We believe value remains to be conquered as we continue our economy’s recovery cycle. We leave the glitz of day-trading to others. Patience, discipline, and focusing on fundamentals remain the preferred strategies to a positive breakout toward new highs. Be consistent; investment over speculation is often a better long-term plan.

As long-term investors, we suggest as always this is a time for discipline regarding diversification (across and within asset classes, international as well as the U.S.) and periodic rebalancing. As a reminder, just as panic is not an investment strategy, neither is FOMO (fear of missing out).

Have a great summer!

Your Bluerock Wealth Team!