March marked the one-year anniversary of last year’s stock market low, as COVID fears continued to intensify and lockdowns were beginning. Since that time, a flood of government support prevented the economy from enduring a depression and fueling a remarkable market rebound.
The first quarter of 2021 provided investors additional growth. Another round of government stimulus and an accelerating pace of vaccination is driving optimism unleashing pent-up demand, reinforcing the investment theme “Green Light = Go!“. Yet returns tend to be less exuberant and more volatile as new bull markets enter their second year. This is not a “bearish” forecast; but rather an acknowledgement that market dynamics can be more frustrating in “Year Two Following the Low” even as economic fundamentals become more robust.
Indeed we are already experiencing a more choppy start to 2021. Much of the volatility relates to concerns about inflation – a topic of frequent client questions as the huge sums of government spending are recognized. The “Roaring 20s” was a decade of surging economic growth following recovery from wartime devastation and pent-up demand. 100 years later, there are some interesting parallels and other key ingredients causing many to wonder if higher inflation is on the way and how it may impact their portfolios.
Our personal finance article this quarter, “ARPA What?”, reviews how the most recent economic stimulus package is way more than direct payments to individuals/families; some strategic planning opportunities exist for many even if they do not qualify for a stimulus check.
A printer-friendly version of our quarterly newsletter can be obtained here: Q4 Nvest Nsights
GREEN LIGHT = GO!
Fresh stimulus spending from the government combined with the Federal Reserve’s pledge to keep easy monetary policies in place for the foreseeable future helped the stock market notch a continuing gain in 1Q2021. Huge government stimulus spending around the globe is a green light for stocks. We are “Go” for the second year of the new bull market that began on March 23, 2020. The S&P500 gained +6.2% during the first quarter extending the 12 month “rocket ship” rise totaling almost +81% (through 3/31); fastest rise ever. Frenzied trading existed in riskier parts of the stock market, and style shift from growth to value and large-size to smaller-size companies was noticeable.
Since the trough in valuations 12-months ago, stock price-earnings ratios today feel/appear extreme. Investors sit at a point where the economy and earnings recovery should cause valuations to contract and return to more normal. The economy and company earnings will likely experience exceptional growth this next quarter which should be a welcome occurrence for long-term investors to stay the course. Worry can develop to “cash-in” following such a robust recent market recovery; the logic being that “it can’t keep going.” Worries about too much government spending only add to the concern about valuations and inflation expectations (see other articles).
During 1Q, investors sold bonds (causing yields to rise) on the worry that a sharp economic recovery will be accompanied by higher inflation. Rates usually rise, sometimes quickly, when economic recovery is fast occurring off the low. Interest rates on 10-year US Treasury bonds rose from 1% at year-end to 1.7% during 1Q. That’s a big move in a short period; a surprise to most investors. Higher rates are good for banks, making loans more profitable. Key also, risky areas of the bond market do not show stress (they historically signal sinister activity earlier than stocks). But rising rates will slow the advance of the stock market, and lend to greater volatility. A slowing advance in stock prices coupled with rising company earnings from an expanding economy allow valuations to return to better levels. Seldom do markets see a significant stumble while fundamentals remain strong.
The outlook for 2021 looks good, but don’t expect the exuberant pace of last year. Tactical changes we made to portfolios last year still offer merit. Small and mid-size stocks should continue advancing better than large; small also performs well with rising inflation expectations. Value-style stocks should provide attractive performance relative to growth. And, international stocks should provide benefit due to 4 reasons: better (lower) valuations than domestic; being earlier in their economic recovery; less political changes being forecast; and a US dollar that looks positioned to weaken against other currencies. Investors’ performance expectations should be upward for 2021, but tamed because of increased up/down volatility versus last year. It is important to keep looking forward because the “green light” is lit. Portfolios will again incur rebalancing during the year to maintain investment objectives relative to established asset mix (risk control) profiles. This can be achieved via new money deposits to an account, and/or by our making trades that return exposures to pre-existing investment targets. Managing risk is very appropriate for long term disciplined investment success.
–Bill Henderly, CFA, Nvest Wealth Strategies, Inc.
YEAR TWO FOLLOWING THE LOW
March 23 marked the one-year anniversary of last year’s stock market low as COVID fears were quickly rising. Since then, the market provided a surprisingly huge rebound largely driven by massive fiscal spending (stimulus) and low interest rates, wherein the US money supply expanded 25% during 2020, and is followed by another 12% increase in early 2021. The economy was/is unable to fully utilize this huge amount of new money; it did not need it all to finance its growth. The extra $$$ were “poured” into the financial markets propelling the best ever rise off the low. Most investors were greatly surprised by this rapid market rebound. Markets often provide important reminders – timing the market (getting out and in) proves ill-advised.
Investors should be aware how different year 2 off the low historically looks. Performance for stocks is likely to be more in line with historical averages, and it’s rarely a smooth experience. The 2nd year of new bull markets historically produced an average advance of almost +13%, but also endured an average pullback of -10% at some point. That means volatility, or a grinding experience should be expected. This is not bearish despite pullbacks always feeling uncomfortable; rather just the historical dynamics of market action. Also, we should be reminded that this second year coincides with the first year of a new Administration in the White House. Since 1950, every first year of a new administration produced a positive performance experience, albeit with increased volatility. That’s due to uncertainties created by announcements of new/different polices (spending, tax, regulation, etc.).
There is some irony in this story. Last year (2020), did you question, “how can the market be up so much when the economy is so bad?” Now in year two the narrative is quite to opposite, “the economy looks better, maybe even great, but gosh this market is a grind!” Maybe it’s appropriate to state that volatile market action may feel frustrating (in light of last year), but unlikely to prove fatal. Any pauses/correction is not necessarily the start of something worse, especially when so much of the market is participating in the advance. The transition from year 1 to year 2 of a new advance exhibits this reputation. The key is not to get too defensive. Bull markets usually run an average of 62 months and rise +181% (the last one ran over 132 months, or 11 years).
Will you consider a really “contrarian” idea? Could we be in the midst of a long-run “secular” bull market advance? March 9 marked the 12th anniversary from the “generational” 2009 low from the great financial crisis. In that time the S&P500 advanced +480%. The idea of a secular bull market (means longer term vs cyclical) includes more than one bull market. Because the “COVID” bear market drawdown was very sharp and short, some make the point that a secular bull market is underway. The last secular bull market ran from 1982 to 2000 producing a +1389% rise; and another ran from 1942 to 1968 producing an advance of +1350%. Each of those periods contained cyclical bull and bear markets, but the longer-trend was definitively up. Since March 2009, there were 8 meaningful drawdowns during the current advance; each provided a pause to refresh before the market rise continued. Is the new 1-year old (cyclical) bull market part of a 12-year secular bull market? Interesting; but does it even matter? The key for long term investor success = stay a long-term investor.
ROARING 20s
The 1920s in the United States is often referred to as the “Roaring 20s” because it was a decade of surging economic growth and widespread prosperity. It was a recovery from wartime devastation and deferred spending, creating a boom in construction and rapid growth of consumer goods such as the automobile and electricity. The “jazz-age” flappers defied Prohibition, indulged in new styles of dancing and dress, and rejected many traditional standards. In general, the decade created the largest wave of prosperity the world ever witnessed.
Does history repeat? 100 years later, some market participants are wondering if this decade of 2020 will be similar. It seems early, it’s only 2021. At a minimum, vaccines are proving effective for economic reopening, and allowing the economic recovery to progress quickly. The reopening of the economy is likely a massive rise because of huge government and monetary stimulus. The huge increase in money supply is way more than required by the economy to finance itself. As stated before, excess $$$ flows into financial markets and real estate aiding them with significant jumps in prices. Low (no) interest rates make financing cheap and attractive. Almost sounds like the 20s of years ago!
Are you uncomfortable with the idea of limitless government spending? In 2020, two stimulus spending packages were completed amounting to $3.3 trillion (16% of GDP); each package on its own was bigger than any fiscal package in the past 50 years. That’s on top of the Fed buying trillions of bonds in the financial markets and holding short term interest rates at 0%. Just days ago, Washington approved another $1.9 trillion stimulus plan. Putting the size of the various packages in perspective, the CARES Act was passed at the height of the pandemic when unemployment was swiftly increasing to 15% and the US economy was on the verge of a pandemic-induced shutdown. It turned what likely would be a depression into just two bad quarters for the economy with the opportunity for a strong rebound. The opposite scenario exists today just 12 months later. Currently, the unemployment rate is 6% and still improving with the economy, which is on the doorsteps of a massive re-opening of growth. The late Senator Everett Dirksen (1960s), cautioned that federal spending can get out of control, observing “A billion here, a billion there, and pretty soon you’re talking real money”…Except today it’s a trillion here and a trillion there. Independent economic research firm Strategas recently observed, “Never has so much money that didn’t exist been spent on so many by so few.”
Is so much government stimulus the recipe for inflation? Is inflation on the way? That’s a frequent question right now (see chart below showing how often inflation is being researched). Ingredients for inflation exist – economy is showing a sharp recovery with vaccine deployment; supply-chain bottlenecks exist; and oil/commodity prices are rising. Accelerating inflation is now the base case in 2021. Yet the Fed expects the 2021 run-up in inflation to be transitory, slow moving and global in nature. Policymakers are focused on unemployment and underemployment, and are willing to let the economy run “hot” even if inflation jumps upward temporarily. It’s difficult to change from deficit spending when the whole world is doing the same. The most important current topic for debate – how long will markets allow deficit spending with no apparent cost to occur? Market participants are trying to get comfortable with this approach. Investors should expect that bond vigilantes will weigh-in on the topic from time to time by pushing interest rates up to challenge the Fed’s plans. We are keenly aware how bonds are poor performers during rising inflation due to fixed interest rate returns; stocks perform well against a general rise in inflation; real estate, oil and commodities do well like stocks; hyper-inflation (not forecasted) hits most assets hard.
The COVID-induced fiscal spending spigot is likely closing. That could be good news and validate the Fed’s perspective any inflation jump will be temporary. The recent new infrastructure spending idea of $2+ trillion also includes a $3 trillion tax bill. IF both spending and taxes were to pass in coming months, infrastructure spending would take place over 8 to 10 years, or more. Unlike earlier stimulus bills (a flood of money), the infrastructure proposals translate into very small increases to annual GDP growth. Tax increases (higher corporate, capital gains and dividends) will create a fiscal drag immediately, likely starting in 2022. Tax increases are immediate while infrastructure spending is slow and spread over many years. Together, these create a “push-pull” variable to future economic growth. Saying it differently… a year ago, it was hard to get worse than worst. 12 months later are we close to the opposite… it is better than best? But new taxes and spending will not boost from the height at which the domestic economy sits. It seems unlikely to get better than best. Massive stimulus policies will fade with COVID, and perhaps inflation too.
Keep a close watch on inflation expectations and bond vigilantes. Currently, the bond market does not exhibit stress points that suggest anything sinister occurring in the near term. When low quality bonds show rising rates faster than the market, it could signal that Washington policies (fiscal and monetary) are being poorly viewed by investors. Market vigilantes can speak loudly when they dislike policy direction. For present, stay invested and watching. Don’t pursue “Roaring 20s” reckless investing practices that incorporate undue risk; keep pursuing proven long-term disciplined investment principles.