Two steps forward one step back….
February played out in similar fashion to January. During the first half of the month the market advanced, only to see a drawdown during the second half. For the month, the S&P 500, while up over 6%, trimmed its gains to 2.6%. The bond market fell over 2% on the month. Small caps outpaced the broad market, advancing 6.5%, while the NASDAQ 100 lagged, ending the month up .9%.
MARKET DRIVERS
The big news of the month was all about interest rates and inflation. Rates have been on the rise over the past six months as the economy shows ongoing signs of repair, but the pace of change this year became more dramatic. The market is digesting what a rapid rise in yields will mean for the stock market, and the economic recovery overall. Higher rates increase borrowing costs, reducing each unit of earnings potential, and inflation can also increase the input costs, adding to earnings pressure of corporate America.
We are of the opinion that the market and economy can absorb a 1.5%+ yield on the 10-year treasury (the presumed “risk free” asset, upon which almost every other security’s relative risk is based), but it is the rate of change that is becoming a concern to the market. By historical standard, the rise in rates, from .5% in August 2020 to 1.48% at the end of February, is quite significant, over this short period of time. During the past decade (since the great financial crisis) rates have been kept low by The Fed, through various bond purchasing programs and other forms of quantitative easing. This ultra-low rate period created a T.I.N.A. (there is no alternative) environment which supported additional risk taking simply to obtain some form of yield elsewhere (ie: stocks). However, as the pandemic impacted American corporate earnings, as Treasury yields are on the rise, the yield on the S&P 500 has been in decline. We are at an important inflection point where the 10-year treasury is providing a yield greater than the S&P 500, creating “competition” for investor dollars, potentially removing the T.I.N.A environment.
Inflation has been headline-worthy, as demand picks up and supply chains continue to be disrupted from the pandemic. However, reflation is quite common coming out of recession and as economic activity increases. Inflation, and to some extent rising rates, impart confidence in the future and better days ahead. It is our opinion that we are seeing signs of inflation, and higher rates, for the right reasons – that the economic cycle is rotating from contraction (recession) to expansion. Again, it is the rate of change in these metrics that are prompting market participants to question the valuation levels of stocks, whether prices have come too far too fast, and to what extent rising rates can support historically high stock valuations. At this juncture we are not overly concerned and feel that the market will get back to a more stable environment.
Earnings growth from the pandemic lows continue to be impressive, so perhaps earnings will “catch up” to valuations, bringing price-to- earnings ratios closer to historical averages. Or perhaps stock prices will need to come down if earnings growth flattens. A more likely scenario is meeting somewhere in the middle. The question becomes to what extent stock prices fall to get to that middle ground. We should all have tolerance, and anticipate some degree of declines in stock prices, if only given the huge run up from the March 2020 pandemic lows. The S&P is up around 65% from the March lows, and its not unexpected for it to take a breather.
PORTFOLIO ADJUSTMENTS
We continued to adjust the exposure to risk assets during the month, increasing allocations to small caps and large cap value. Continued reduction of mega cap tech and growth names have been the source to reallocate into the more productive areas of the market. However, during periods of drawdown like we saw at the end of the month, most equity styles become correlated as the selling intensified. Adding a little more pain to the declines was the fact that bonds did not provide the typical non-correlation to stocks, as both stocks and bonds declined. But during relief rallies, or perhaps more sensible trading, small caps and value and other economically sensitive areas of the market rebound more than mega cap tech and growth under most observations. It is a game of inches, and we continue to perform in line with our benchmarks YTD.
LOOKING AHEAD
The market feels a little shakier over the past few months, and that is understandable. However, earnings continue to improve, which at the end of the day is what truly matters to the price of a given stock. Though market volatility has picked up this year, the overall trend remains up and to the left. As surmised in past notes, we anticipate continued volatility moving forward, but do not sense a market crash or correction is imminent. We hold these beliefs even as rates are moving higher, though are still low by any historical measure. The Fed will continue to advocate low rates and accommodation until the economy returns to full employment, and the economy is flush with cash, which needs to eventually find a new home as savings yields are still next to nothing.
Enjoy the final weeks of winter as the days get longer and the changing of the seasons is right around the corner. Stay safe.
