After a great start to the quarter in July and August, the storms hit. Here in the U.S., markets pulled back significantly. The Dow declined by 4.2% for the month and 1.46% for the quarter. The S&P went down by even more for the month, at a 4.65% decline, although it gained 0.58% for the quarter. The NASDAQ trailed by even more, at a 5.27% monthly drop and a 0.23% loss for the quarter. Abroad, international markets were also hit, with developed markets down for both the month and quarter, at 2.9% and 0.45%, respectively. Emerging markets dropped 3.94% for the month and 7.97% for the quarter.
Stocks faced some severe headwinds last month. Take your pick of the biggest culprit: the Covid Delta variant, the debt ceiling, China’s Evergrande fiasco, inflation, supply chain problems, or higher interest rates. They all weighed heavily on Wall Street.
Inflation and Rates Concern is Growing
Bond yields are rising globally as monetary policy becomes less accommodative amid continued upward pressure on inflation. The Bank of England’s comments about the potential for inflation to become more persistent may have been a wakeup call. Most investors thought inflation pressures were transitory, but as prices continue to rise, many now believe inflation will be a bigger problem than they previously thought. We saw inflation breakevens (i.e., the gap between nominal yields and TIPS yield) also move up a bit, signaling that investors may expect some stickier inflation. The 10- year Treasury yield closed higher than 1.5% for the first time since June, but it remains below the highs it experienced in March. The increase was largely driven by the Fed hinting that it will likely announce the beginning of the taper process at the November meeting and that tapering should be finished by mid-2022. The Fed also increased its outlook for growth, inflation, and policy rates for 2022. The Fed and other central banks indicated a tolerance for higher inflation, stemming from the last decade’s long stretch of below-target inflation and concerns that the COVID-19 crisis could drag growth longer term. Nonetheless, this strategy is a significant shift from previous cycles, when the Fed tried to act pre-emptively against rising inflation. On balance, we expect long-term interest rates to rise further, reflecting a reacceleration in global growth, which should present an opportunity for value and cyclical stocks to outperform.
Happenings in Congress
The Treasury market remains volatile as Congress examines two massive spending bills: the $1.2 trillion infrastructure bill and the $3.5 billion Build Back Better Act. A proposed $3.5 trillion bill that focuses on expanding Medicare, addressing climate change, and boosting social programs is even more complicated. That bill, which includes both corporate and individual tax increases, is bogged down in a tussle among Democrats over its size and scope. The bill will likely have to be significantly downsized to win the support of moderates in the Senate. Expect negotiations to continue through much of October.
Is the dot-com bust happening again, right under our noses?
In July 2021, Jeremey Grantham of GMO said, “Looking at most measures, the market is more expensive than in 2000, which was more expensive than anything that preceded it.” It might seem an odd claim, but the speculative boom-to-bust of late 1999 and the first half of 2000 does bear some resemblance to what has happened over the past nine months in the fashionable areas of clean energy, electric cars, cannabis stocks, and SPACs. The similarities are in both performance and investor behavior. The late-1999 fear of missing out on internet stocks inflated the Nasdaq Composite 83% from the end of September to its March 2000 top. Pets.com, an online retailer of pet food and accessories that became one of the symbols of the dotcom bust, reached a peak market capitalization of $290m. Today, Chewy Inc., an online retailer of pet food and accessories, is capitalized at $32bn. Relatively young companies have reached eye-watering valuations (Tesla trades at 20 times sales) and online traders have driven the price of so-called “meme stocks” such as video game retailer GameStop, to the moon and back. The gains have encouraged investors everywhere, including in the UK, to put more money into tech. Are the tech stock fundamentals as diverged from their price in 2021 as they were in 2000? Probably not, as other factors such as monetary and fiscal stimuli are driving prices higher, along with low rates and inflation. As rates have risen in the last few weeks, tech selloff has intensified, but that escalation is not necessarily due to poor fundamentals.
Overall S&P 500 index performance suggests a relatively tame market, but considerable churning is present underneath the surface. Not only have sector rotations remained swift and sizable, but many stocks within the S&P 500 have already reached correction territory this year. While the S&P 500 has yet to see even a 5% correction in 2021, nearly 90% of its members have already had at least a 10% correction at some point. The underlying weakness also suggests some fundamental challenges the economy is facing in the near term, not least being disagreements in Washington over the debt ceiling and the likelihood of slower economic growth in the latter half of the year. Pressures from supply chain-related constraints and subsequent inflation concerns are still acting as headwinds for the economy. Depressed inventories — which caused second-quarter real gross domestic product (GDP) growth to be slower than expected — are taking longer to rebuild. Meanwhile, consumption (particularly within the services sector) is cooling, evidenced by the flat growth in restaurant retail sales in August.
On the positive side, GDP growth has been north of 6% for two consecutive quarters, and expectations are for a similar jump in the third quarter, implying we are early in the cycle and experiencing a robust recovery, though some data series show a recent softening of the positive trends as the stimulus wanes. The overall unemployment rate is 5.2%, well above the 3.5% level seen pre-COVID, while the 61.7% labor force participation rate is a full 1.5 percentage points lower than the peak levels seen early in 2020. Both statistics suggest ample slack in the labor force to meet the growing demand for workers. Market pricing appears to afford no margin for error, despite the potential for meaningful volatility due to a mistake by the Fed, higher inflation, slowing growth, the effects of elevated leverage, a change in the course of the COVID virus, or myriad other factors. Financial markets across the board are priced for perfection, and as value driven investors, we are generally going to be underweight perfection, which would suggest that caution in these times is warranted.
Market volatility is unsettling, but it’s not historically unusual. If you’ve built an appropriately diversified portfolio that matches your time horizon and risk tolerance, it’s likely the recent market drop will be a mere blip in your long-term investing plan. However, it can be hard to do nothing when markets are rough. Your Bluerock portfolio managers focus on the fundamentals. Maintaining focus on high-quality segments of the market (e.g., companies with strong balance sheets — meaning strong sales and earnings relative to total assets) historically tends to work well in an environment that is still choppy, especially as the trajectory of the Covid virus continues to influence market and economic results. Given what has been happening recently, consider a few of the investing principles we employ:
- Don’t try to time the markets. It’s nearly impossible. Time in the market is what matters. While staying the course and continuing to invest even when markets dip may be hard on your nerves, it can be healthier for your portfolio and result in greater accumulated wealth over time.
- Build a diversified portfolio based on your tolerance for risk. It’s important to know your comfort level with temporary losses. Sometimes a market drop serves as a wake-up call that you’re not as comfortable with losses as you thought you were, or that a portfolio you assumed was appropriately diversified in fact isn’t.
- Build a financial plan and stick to it.