It’s Different This Time November 2, 2021
I’ve written a lot about the yearly money flow patterns into the stock market. As a quick recap, in a normal economic cycle, stocks tend to start the year off on a positive note. That usually lasts into early spring. Often markets are listless during the summer months, with late summer into early fall often being a sustained period of volatility and historically of larger market declines. However, as the leaves start to turn and those of us in the north know that winter is coming, the probability of a market rally heading into year’s end becomes more likely.
This pattern has played according to the script in 2021. We usually represent the stock market by using the S&P 500 as it is a well-known institutional benchmark. It rallied from January through mid-May. Markets true to form basically marched in place through beach season. I said in my last letter to you which went out at the end of August that we could see a return of volatility in the early fall based on these historical patterns. True to form, through mid-October stocks traded not much higher than where they sat on Memorial Day. September saw the only monthly drawdown we’ve seen in 2021 with the major indices off about 5% on average. Underneath the surface and away from the influence of the 10 largest stocks in the S&P 500, the average stock struggled. Nearly half of the growth stock universe has at some point lost 20% of its value in 2021. Major technology indices until recently were no higher than they were when the kids were let out of school in June. {Except they didn’t go to school last year, but that’s a story for another time.} We’ve now rallied off those lows and markets appear to have entered a more bullish pattern. If the augers are to be believed probability would suggest we could see this continue until 2021 ends, with the only real question being how much from here does a year-end rally take away from 2022’s returns. Unless the world becomes undone in the next 9 weeks this year is close to being in the books from the investment world’s perspective. It’s time to start thinking about what comes next year.
Before we do that though I want to say you are unlikely to uncover this good news by watching or reading the financial press. Their job is to basically report on consensus thinking with a bias towards the negative. The financial media is always looking for reasons why the market can go down. Good news doesn’t sell. In over 30 years of doing this I can’t ever think of a time when the press called for a bull market. When things are really bad, the stories are about how much worse it will get. When things are good there’s always the story of the next financial phantom lurking in the shadows. So, as we close out the Halloween season let’s address some of the hobgoblins being thrown out for why impending doom is coming. Some of the prime suspects right now are inflation, budgetary issues in Washington, size of the Biden fiscal package, China and rising interest rates.
Inflation is worrisome but I believe that much of its issues stem from a world economy trying to get back on track after basically shutting down for a year. Most of inflation's problems will likely go away when supply catches up with demand around the globe. Go reread my article "The Best Years of Our Lives" on why I think that. One way or another the Government will avert a debt crisis. This same issue comes up about every two years. In the end everybody finds a way to keep the money presses rolling. There will be a fiscal package and tax changes. People are just arguing scope and size. It will be less than liberals want and more than conservatives are willing to spend. That's just how it always is. That’s why we call it democracy. Nobody gets everything they ask for. China is the grand foreign policy challenge of this century and will never be far off the back burner. It will flare up from time to time. Taiwan is on the front pages right now, but I don’t see serious military people suggesting an invasion is imminent, nor do I see evidence that right now the Chinese are willing to tolerate the political, military and economic blowback an invasion would produce if it were to occur. So finally let's consider interest rates.
The 10-year US Treasury bond trades at basically 1.55%. A 30-year US bond yields slightly under 2% right now. These yields are low but have moved up about a quarter of a percent over the summer and are trading near highs seen in the past year. This has sparked fears that perhaps interest rates will move higher in the coming months. Now for the past year these low yields are one of the reasons that stocks have traded at valuation levels that would normally be worrisome. At what level do interest rates become a problem for the stock market and the economy? I don't know and obviously right now that seems like a problem off well into the future. But think about it for a second. We have borrowed trillions to fight the virus and will ultimately end up borrowing trillions more under the Democrat's fiscal proposals. At what point do the public debts of the US start to concern the investment community. My guess is you have to see the 10-year approaching 3% and the long bond nearing 4% for bonds to start becoming serious competition for stocks.
When you buy bonds at such low yields what you’re saying is you’re willing to park your money in an investment that will likely not even keep up with inflation over the life of the bond just to get your principal back. Contrast that with a simple S&P 500 ETF. These currently have dividend yields near that 10-year yield with a chance to also see those dividends grow over time. You also get the potential for growth when the economy improves that has historically been in the 4-6% range. To me the obvious longer-term choice is the ETF. However, you have to be able to live with the market's volatility. If you've done a proper asset allocation and have a solid understanding of your own personal risk/reward scenario this volatility is easier to tolerate.
“It’s different this time!” This phrase is usually uttered by professional investors filled with hubris. These are folks who’ve often ridden a hot hand and argue for their continued success by pointing why and how the world has changed in order to justify their investment views. Pride commeth before the fall has a way of usually panning out in my line of work and Wall Street is littered with the specters of once great investors humbled away into nothingness because they refused to see the world had changed and were unwilling to change their investment stance accordingly. With respect to that tradition then, I’m going to slightly break with that tradition by arguing that this time it ISdifferent. However, that doesn’t necessarily mean I think the market is going to continue moving higher like a runaway train. Here’s my thoughts.
As time passes it’s becoming clear that the pandemic was a demarcation in time, everyway as significant as Pearl Harbor or the 9/11 terrorist attacks. By this I mean the pandemic has altered things so significantly and changed things so dramatically in a very short timeframe that there’s no going back to the world before. The severity of the pandemic may have abated somewhat {at least in wealthy nations}, but it has wrought lasting changes to all facets of society. It is different because we continue to see technological achievement growing at a continued rapid pace. Since I last discussed innovation with you there have been announced break throughs in robotics and drone technology, lithium metal batteries for electric cars, a new vaccine for malaria, smart propulsion systems for satellite constellations, systems to bring down the cost of solar technology and green hydrogen to name just a few I’ve read about in the past few months. It is different now because we continue to see China become more assertive on economic and political fronts. It is different because we continue to see interest rates hovering at historic lows. It is different because for the first time in over half a century we are seeing the Federal government assert itself more directly in the economy. Along with that has come a rise in inflation as global supply chains remain badly broken. The world as it existed before January 2020 is gone. Its trajectory forever changed. To not recognize that would mean I’m not doing my job as an investor of your money.
However, I’m also not arguing the parabolic bull market we’ve seen from the spring 2020 lows must continue indefinitely. Markets phase between short and longer-term cycles. While I don’t think the secular bull market we entered in the spring of 2020 is even close to being over, I could see it pausing for a bit. I made the case back during the worst of the pandemic’s market collapse in a series of letters and posts that equities were extraordinarily undervalued. That argument cannot be made today. Depending on how one views it stocks are either somewhat overvalued or extremely expensive. My view is that we’re in the moderately overvalued camp right now. We can sustain a period of higher valuations because bonds comprise almost no competition for stocks. It would take long rates going into that 3-4% range in my opinion for bonds to syphon off significant cash flows from the markets. Given all that and given what I see as a now more elongated global recovery I think US markets have the potential to grow on a total return basis from this writing out over the next twelve months 6-10%. That calculation may go higher or lower depending on how we finish out 2021. That doesn’t mean that it will happen like I’m laying it out here, but I think the potential is there for that kind of growth.
However, {and please read this next part!} assuming seasonal patterns play out between now and year end, markets will have rallied for nearly two years without so much as a correction of greater than 10%. All bullish phases end. Most of the time they don’t crash, that’s too obvious and occurs only when markets are caught offsides by an unexpected event. A pandemic is exhibit one for this. Instead, they often just peter out. One wakes up after six months or a year down the road and realizes that prices haven’t moved all that much in the intervening period. In other words, bullish phases sometimes take a pause, letting time instead of price correct any overvaluation in the markets. Sometimes it’s a bit of both time and price. That could be our fate over the next couple of years, which wouldn’t be the worst scenario given what we’ve been through. However, a market that goes nowhere usually sees an increase in volatility. By that I mean that there is now a greater probability now that we could see much bigger gyrations in market prices and we need to be prepared for something larger than a small drawdown in investment accounts. I am still longer-term bullish given reasons previously stated and what I think will be better than perceived economic growth in 2022. But probability suggests we could be entering a different phase of this bull market come next year and we at a minimum need to be on guard just in case the game is about to change.
I’ll be back towards the end of the year with a further update on my thoughts regarding this potential.
*Long ETFs related to the S&P 500 in client and personal accounts.
Christopher R. English is the President and founder of Lumen Capital Management, LLC-a Registered Investment Advisor regulated by the State of Illinois. A copy of our ADV Part II is available upon request. We manage portfolios for investors, developing customized portfolios that reflect a client’s unique risk/reward parameters. We also manage a private partnership currently closed to outside investors. Mr. English has over three decades of experience working with individuals, families, businesses, and foundations. Based in the greater Chicago area, he serves clients throughout Illinois, as well as Florida, Massachusetts, California, Indiana, and other states. To schedule a complimentary portfolio review, contact Chris today by calling 312.953.8825 or emailing him at lumencapital@hotmail.com.
