Calm Seas, Turbulent Waters
To the casual observer, the stock market has been meandering along, setting new all-time highs since the beginning of the year. If that were the whole story, investors could feel comfortable sitting back and just watch small incremental gains being made in their accounts.
However, the truth is that while the major market averages have demonstrated calm, what is happening underneath the market has been turbulent with some very violent price swings in individual stocks, industries, and sectors. For example, growth stocks began the year with spectacular gains for the first six weeks. Then, over the next three months, growth stocks gave up those gains and experienced losses between 10% and 20%. The price declines were so dramatic that growth stocks were in bear market territory.
On the other hand, value stocks began a resurgence after ten years of being laggard performers. The simple analysis would suggest that this was just a normal market rotation from growth to value. However, what was occurring was anything but simple. As money exited growth, it began to show up in financial stocks. It stayed there for only a few trading days and moved to transportation stocks. Again, it stayed there only a brief time and then it was on to commodities….then to housing, then to retail stocks. Then, energy stocks took their turn to lead the pack. In the last couple of weeks, technology is back in favor. As of July, this internal rotation underneath the market continues as money flows in and out of sectors without any long-term trend being established. The rotation has also affected small cap, mid and international stocks as well. All have had their “15 minutes of fame”, only to give the gains right back.
From a portfolio management perspective, this has been a difficult stock picking environment. We sold virtually all growth stocks back in March/April and preserved the huge gains of 2019 and 2020. We then deployed the funds to the areas in the market that were working well. But, as noted above, we could not stay long in those new investments since money was again moving to another segment of the market. The bottom line is that we have had to execute thousands of trades to keep up with the turbulence under the calm market.
Now that you know the challenge that was faced in the first six months of the year, you might imagine that the more conservative portfolios (Income, Conservative, Moderate and Global Equity Income) have done exceedingly well in the first half. The more aggressive portfolios (Long Term Growth and Aggressive Growth) have lagged since growth stocks ceased to produce gains. However, the growth stock rally of the last three weeks is encouraging. But, in this market, we just do not know if there is permanence to this resurgence. As always, we monitor all portfolios daily to detect further market rotations and adjust to them accordingly.
Below we will discuss the major pressure points on the markets, just to inform you of possible turbulence over the Summer.
Delta Variant – Back to the Future
Over the past seven months, America has made incredible strides in containing the Covid virus as the vaccine program was rolled out and Americans rolled up their sleeves. With an almost 70% vaccination rate, the spread of the virus has slowed in most parts of the country. Unfortunately, the virus could mutate among vulnerable populations, and we now have the Delta Variant that seems to possess the ability to spread more rapidly, resulting in new waves of disease in parts of the country where participation in the vaccination program is below average.
Elsewhere in the world, the situation is far worse. Vaccination rates in Europe are far behind the U.S. In Africa and parts of Asia, vaccines are in short supply and today there is not a comprehensive global program to fund and manage a worldwide vaccination program. Thus, variants of the virus are free to develop and compound the public health problem.
So, what does this mean? Aside from the human loss of life (4 million dead and counting), there are economic consequences multiplying today. Tokyo just announced no spectators at the Olympics as Japan has a very serious virus problem on their hands. Europe is implementing new economic shutdowns which will slow corporate earnings. U.S. companies are now considering slowing hiring and production considering potential lower foreign demand for goods and services. If we take this all together, the rosy forecasts of a month ago for global economic growth are starting to melt away. It remains to be seen how dangerous the Delta Variant is, and how quickly governments can respond to the new threat. But we think it is safe to assume that markets are beginning to factor in lower growth, productivity and market returns over the next nine to twelve months.
Earnings season in the United States kicked off this week. The earnings numbers will knock our socks off. Year over year growth in corporate revenues and earnings per share will sparkle. Typically, the markets would migrate higher in response. But let us not forget that the Delta Variant impact is lurking right around the corner. We also are casting a cautious eye on domestic inflation (please see the Spring newsletter for commentary on the inflation risk). So, it is reasonable to assume that more market choppiness is very possible as we move towards year end and into next year.
When we enter 2021, the national debt level was elevated due to decades of higher spending and lower revenues (tax cuts). As the pandemic hit, the Federal Government rolled out a series of new spending programs without commensurate new revenues. The debt is now 100% of U.S. Gross Domestic Product (GDP). With the new spending approved this year, debt will rise to 108% of GDP. President Biden is advocating for additional spending (and tax hikes). If the spending goes through without new revenues, debt may grow to 114% of GDP by next year. Our previous record was 106% after World War II. As Baby Boomers move to Medicare and Social Security, child tax credits take full effect and taxes remain relatively constant, the debt level could reach 130% of GDP.
Eventually, something must give. As debt rises, interest costs to the Treasury will rise, driving interest payments to a much larger slice of the U.S. budget. A default on our debt is out of the question, since the largest holder of our debt is….the U. S. Federal Reserve. From our perspective, we have about three to four years to address this elephant in the room. If the pattern of larger spending and fixed revenue is not addressed, it can have serious consequences. More money flowing to larger debt payments will rob the economy of needed capital, potentially leading to slower growth. Slower growth could lead to a lower standard of living for Americans. This spending/tax/debt scenario will tend to slow stock market returns as well. Therefore, as investors, we have a vital interest in bringing our financial house back in order. This is not a political statement to indict one political party or another. Indeed, both Republicans and Democrats have their fingerprints all over this possible financial crisis. The clock is ticking.
Everyone needs Good News
The U.S. economy is truly in fine shape. This week, retail sales posted a very strong number as consumers are back spending. Manufacturing data shows that expansion is steady and consistent. The Service Sector reports even stronger expansion. The last job creation number was great. And, the wage data suggests that incomes are rising, virtually every month.
The Federal Reserve continues its accommodative interest rate policy which has supported economic expansion and stock market gains. The Fed is also of the opinion that recent inflation will be transitory and not present a significant economic hurdle down the road. With vaccination success, we have reopened major parts of our economy, and we believe that new shutdowns will be rare and very targeted (if needed at all). Finally, we think that major new tax increases are unlikely given the split between Democrats and Republicans in Congress.
Thus, our overall market outlook is positive but tempered by the Delta Variant and Debt concerns noted above. We continue to find stocks and fixed income investments that are very productive. We currently have 19 positions in our portfolios that have returned between 10% and 50% since January 1st! Each week, we discover new opportunities that we think can potentially produce similar results in the second half of the year. We just are unlikely to have a repeat of 20 plus percent returns of 2019 and 2020. Overall, we are delivering good news to you today!
We have been blessed with clients who regularly refer their friends and family to us. We are deeply grateful and appreciate the vote of confidence!
However, we often have clients ask us if their referral has contacted us. All too many times, we deliver the news that no contact has been made. So, to learn more about this situation and our recommendation on what to do, please view this brief video. We hope it is helpful.
Are you having fun in the rain?
Spring was cold and raw. Summer started right out of the gate with high heat, it disappeared with the heavens bringing rain, rain, and more rain. We have had it. We are certain that the rest of the Summer is going to be wonderful! So, let us take time to go have fun and enjoy all the friends and family that have been sequestered during the pandemic. Now is the time to seize the day! Jack Frost is not far off, so please hit the beach, jump in a lake, take a long walk, and patronize your favorite restaurants. Celebrating beautiful weather is the best!