On June 30, the S&P500 enjoyed its 34th new closing high of the year, and is now up roughly 95% from its March 2020 low. Remarkable! Our first article, “Ruff & Reddy” reviews the catalysts behind this powerful advance, but also that under the surface there is rotation underway and broader market momentum is softening. This is normal in the second year of a new bull market and is often accompanied by more volatility. Government remains a key factor for the prospect of volatility as well. In that regard, the lyrics of the 1976 Eagles song “Hotel California” may be a good summary of the challenge government may face when they at some point attempt to walk-back from deficit spending or target inflation. In a different way, the song’s lyrics may be spun toward appropriate guidance for individual investors too.
The personal finance article this quarter, “Is Your Beachbody Ready for Summer?“, shares a client’s motivation to participate in a recent stock IPO. We are often asked by clients about various investment ideas – ranging from ‘meme-stocks’, bitcoin, or real estate; this client’s thoughtful approach to an investment receiving lots of buzz provided a refreshing and textbook example of how to avoid potentially unhealthy financial behavior.
A printer-friendly version of our quarterly newsletter can be obtained here: Q2 Nvest Nsights
RUFF & REDDY
Our June commentary was titled “Huff & Puff” which likened the story of “Three Little Pigs” and the big bad wolf to the financial markets huffing and puffing for a breather; or to the markets huffing/puffing concern for prospective inflation. Do you recall “Ruff & Reddy”? Ruff and Reddy are housemates and best friends, featuring a smart and steadfast cat (Ruff), and a good-natured and brave (but not overly bright) dog (Reddy). The “best friends” theme allowed emphasis on humor and wit. Hanna-Barbera Productions produced this half-hour animated series for NBC Saturday morning children’s TV, premiering in December 1957 running for 156 episodes until April 1960. The series is notable as one of the earliest original animated TV programs using limited animation techniques – requiring fewer drawings with less inking and painting to save production costs. Entertainment then was certainly “funny” to watch compared to the current programming format; life seemed simple.
On June 30, the S&P500 produced its 34th new closing high of the year, and rising +15.3% YTD. That’s equivalent to most full year returns, but in just 6 months. Stocks are up +38% over the past 12 months as we cross the mid-point of 2021, and the stock market is now 15 months off the March 23, 2020 low. This new bull market run is both longer and more powerful than two other comparable moves (1982 and 2009 lows), advancing +96.5%. That is a fantastic jump compared to an economy that was in lock-down for most of 2020 during much of the early advance.
Why? What’s the power behind it? Recall that US monetary and fiscal stimulus grew the money supply at an annualized pace of +25% last year, and cumulatively by near +35% to this point; that’s more than the economy can use to finance its growth. The excess is still flowing into financial assets, supporting and boosting prices. Even the prospect of additional fiscal spending (for infrastructure) is deemed encouraging to the financial markets, never mind that its influence will be spread over 5 to 8 years or more.
But under the surface, broader market momentum is softening; 57% of stocks are above their 50-day moving average, compared to the 92% reading in mid-April. Only 8% of Individual stocks made new highs (way down from when the markets were rising fast). June was an “up month” for the S&P500, yet there were more declining (286) stocks than advancing (219); the 4th time for this trait during the current bull market advance. All of these readings reflect a market that’s narrower. Investors are wondering if the recent loss of internal momentum poses a problem. The stock market needs a pause – slowing momentum is normal following the robust advance of a new bull market. Keep a close watch on momentum, but the upward trend of the market is still strong and intact. Trend is more important at this point. Rotation of leaders is also normal and is underway just now. This can create an unsettling feeling for investors when recent winners are lagging behind those that were soft. The market may be saying (or wondering) if pain from the COVID lockdown is not over.
It’s also important to remember that historically the second year of a new bull market is a slower advance, often creating frustration to investors due to pauses and/or a correction despite an economy that seems to be improving. And, 2021 is also the first year of a new administration in the White House. Since 1950, the first year of a new administration produced a positive stock market experience albeit with increased volatility – up/down/up/down. That’s because as new policy and legislative ideas are announced, they create uncertainty. Investors attempt to analyze if proposed policy will be implemented, and that creates volatility. These are two reasons (2nd year of a new bull market, and 1st year of a new administration) 2021 should experience some ups and downs (a third reason is discussed below). It could be a little “ruff” during the advancing process near term. Yet, you must be “ready” by staying invested. Getting in and out does not work. Volatility is not fatal; it’s just part of investing.
–Bill Henderly, CFA, Nvest Wealth Strategies, Inc.
“HOTEL CALIFORNIA” – Outlook, or Lookout?
How do you stop policy (aid) that appears necessary, but also may contribute to the very problem that is trying to be fought (unemployment)? The global financial crisis (2008) was a hinge moment for monetary policy wherein “zero interest rate” (ZIRP) and “quantitative easing” (buying bonds from the financial markets as money was put into troubled banks) were developed and effectively used. During the 2020 COVID economic lockdown, this monetary policy path was again utilized PLUS a more powerful tool of fiscal policy which legitimized deficit spending. This government policy mix poses the possible challenge of long-lasting inflationary pressure. How do governments walk-back from deficit spending which is designed to “aid” the unemployed and struggling small businesses? Strategas recently equated the question to the lyrics of the 1976 song by the Eagles, “Hotel California,” “You can check out any time you want, but you can never leave.” These words summarize the challenge of current deficit spending. Will abandoning government aid prove more difficult than envisioned?
The Fed currently desires inflation to run “hot” and maintains that easy money and current fiscal policy is appropriate until the economic conditions are fully reopened and unemployment reaches lows of the last economic advance. Further, the Fed considers inflation transitory – it will temporarily run hotter – but will return to desirable 2-3% levels over time. Looking at the US federal debt stats: interest expense as a percent of debt is near a 25 year low; near the lowest level on record at 3.6% (due to ZIRP); while actual aggregate (total) interest payments (expense) for all government (and businesses) is at/near all-time highs (again, because of ZIRP there is a loading up on debt). A secular shift upward of interest rates due to higher inflation experiences could present challenges to some heavy-debt companies and government. How do you stop policy (aid) that appears so necessary, but is contributing to the problem of excessive debt?
What is the market saying? Is too much liquidity becoming a bad ingredient for the market? The bond market yield curve is flattening with longer yields dropping. That can suggest inflation is unlikely a problem more than a few years out. Further, with interest rates drifting lower, it implies that economic growth peaked and/or starting to slow. There was a quick economic rise as life “reopened” from the lockdown. But, we may be experiencing peak economic data now, even when unemployment is not back to prior cycle lows. Fiscal stimulus is wearing off with trajectory of economic growth slowing despite roughly 7.5 million fewer jobs. Consumer spending (by both high and low income earners) is above pre-COVID levels but beginning to trend slower; spending is shifting to services – restaurants and travel. Where does the next economic growth boost come from? Employment needs to run full; consumer spending would need to tap savings or credit; or more stimulus. The stock market is also forward looking, and is currently highly rotational in part from rich valuations. Last year during lockdown, growth names with a “click” focus did well. As the economy started to reopen, cyclical and value stocks provided strong performance rebounds. Currently with interest rates sliding in prediction of peak data or slower economic conditions, rotation is underway with growth style leading the most recent advance. Thus, as the markets debate peak data – slowing economic conditions, or transitory, sticky or accelerating inflation, and still high valuations on asset classes – expect market volatility due to uncertain future policy ideas (deficits and/or taxes), and from wondering when the Fed will change current easy monetary policy (end QE and ZIRP). Markets are beginning to think about slower economic prospects for 2022 (see below); even the Administration is using +1.9% real GDP growth plus higher 3% inflation after 2023. These assumptions will lower investment return expectations and return lofty valuations closer to normal.
A few more words regarding inflation as we recall that money supply is some 35% greater (very fast) than it was pre-COVID and was financed via deficit spending/borrowing. The public is in no mood to carry the burden of huge public debt. Taxes or inflation are two solutions to the debt problem, but with different economic outcomes. New/increased taxes (to pay off debt) will slow economic growth which is needed to create full employment. For this reason, some suggest the US needs inflation to run hot…for decades. Inflation may be the policy prescription that is more easily pursued. Inflation is a “tax” on dormant money, and is not currently levied on savers and bond investors, as long-term (running) inflation is not priced in. Inflation is a “stealthy” tax on investors without an act of Congress. Also, currency debasement (which creates inflation) may be the weapon in the new cold war toolkit for the US with China. Dollar devaluation (because of increasing big debt and deficit spending) versus global currencies makes US export product prices more attractive (cheaper); attacking low labor costs in many foreign markets. This is the reverse playbook to the Cold War with the Soviets where inflation was battled (strengthen US$) to drop the price of oil so Russia couldn’t pay military expenditures and their domestic import prices increased (bad for their citizens). Today, government deficits and resulting inflation should keep the US dollar under pressure, allowing US made products to be more attractive for export (hitting on China and other low-wage foreign manufacturers). In a similar way, inflation allows borrowers, like the US, to repay debt with cheaper money. If inflation were 1%, it would take 50 years to bring the ratio of “debt to GDP” down to 80% from its current 110%. At 2% inflation, the “payback window” shrinks to about 20 years; at 3% inflation, the “payback window” whittles down to approximately 10 years.
For investors, checking out of Hotel California is not practical. You may not like what you see, but you can never leave. You can check-out from the financial markets if your emotions push hard enough, you can hold cash because you are worried, but leaving can be very dangerous to your financial health. Bonds do not provide investors relief from inflation. Sticky inflation requires investors to own short duration equities. That is, own stocks with histories of growing dividends where cash flows are returned to investors (not bond alternatives like high yield stocks). Anticipate that investment returns will be lower, muted by the level of inflation and/or taxes (investor’s two enemies). It is proven that owning a diversified mix of different styles of mutual funds/ETFs buffers portfolios over the long cycle of investing, thereby providing attractive long term returns that aid personal financial goals and plans.
–Bill Henderly, CFA, Nvest Wealth Strategies, Inc.
TRADING PLACES
We swapped Diamond Hill Small Cap (DHSCX) Fund into American Century Small Cap Value (ASVIX) in retirement accounts and SPDR S&P600 SmallCap Value ETF (SLYV) in taxable personal accounts in June. DHSCX was utilized in client accounts for 15+ years. The fund and company pursue a disciplined investment process that worked well. Value-style funds were out-of-favor (over the past 12 years) and some management changes generated lower trailing performance results when compared to peers. It is always difficult to swap funds and it creates meaningful capital gains in personal accounts. Proposed capital gain tax increases were also a factor in making the swap at this time; the ETF will provide better tax control if/as tax rules change.
Your quarterly investment report includes several performance reports, one being “Asset Class Performance Summary.” This page provides insight into how the portfolio performed during different time intervals (ie: quarter, YTD, 12 months) for cash, bonds, stocks, and the portfolio as a whole. One interval included is the “New Bull Market”, starting March 23, 2020 to June 30. Interesting how similar are the last 15 months returns compared to the “Last 5 Years” numbers (as applicable). Performance is fully about when you start counting. Do not interpret the similarities in numbers to suggest that timing the market is a good idea, or that it works. Timing the market does not work; is impossible to employ; and it definitely will cause long term returns to be small and unrewarding. Many studies show that missing a few early days of a new bull market, or any market rally, is very costly. Time (an investor’s key ally) rewards all investors for retaining a long-term focus. It’s also very helpful to pursue a disciplined investment process that time proves works. Good news – investing is rewarding as evidenced by time in the market!