As we enter the final month of 2021, we wanted to update you on the market action since our last client note.
October was a strong month for the stock markets, with the S&P 500 index advancing 5.8%, the NASDAQ 100 (QQQ) gaining 7.6% and the small cap index (IWM) lagging large caps with a gain of 5.3%. Large cap growth (RPG) led the pack with a gain of 9.9% while large cap value (RPV) advancing 4.5%. Bonds slipped .5%
For November, the S&P 500 trended modestly to the upside until the week of Thanksgiving, giving up the monthly gains and ending the month down 1%. QQQ held on to a modest gain of .8%, while the small caps declined 7.5%. RPG declined .8% and RPV declined 5.3%. With the equity markets under pressure, bonds closed the month with a gain of .2%.
What’s driving the markets: – Omicron, Fed’s interest rate policy and inflation
As has been the case in prior months, one of the main drivers of market movement has been related to the pace of the Federal Reserve’s normalization of interest rates and reduction of bond buying programs. All eyes continue to be on the Fed, particularly the most recent reading on inflation that printed a year-over-year 6%+ inflation — a rise not seen in 30 years. As we alluded to in our last note to you, the longer inflation rears its head, the less “transitory” it is likely to be. Well, the transitory adjective was dropped from Powell’s most recent speech in November, which, in our opinion, is warranted but also puts more pressure on the Fed to raise rates sooner than not and perhaps even more frequently as previously indicated.
Speaking of inflation, we are all experiencing higher prices on almost everything, particularly in the grocery stores and at the pump. Whether inflation continues to move higher is unknown, but it does put more pressure on the Fed to act sooner rather than later, which is unsettling the market. Higher inflation increases input costs for companies, which (all things being equal) will reduce revenue. Lower expected forward revenue on top of a rising rate environment is causing market participants to re-assess valuations, particularly on those higher growth names. This, in turn, is causing an increase in volatility to levels not seen since the early days of the pandemic. Eventually, the market will sort the valuation conundrum out, and the economic backdrop remains strong, which is positive.
The market seemed to be digesting the inflation/interest rate concerns in stride, adjusting to the likely reality that inflation will stay above the Fed’s 2% mandate for some time; and accepting the fact that interest rates will likely continue to increase.
At the end of November, the new Omicron strain of COVID-19 put a little too much pressure on an otherwise sanguine market environment, likely being the main culprit of the end of November market sell off. We have been here before with the Delta variant, and it is our belief that the world is much more capable of addressing and suppressing the adverse effects of a new wave of COVID transmission than we were at the beginning of the pandemic. In our opinion, the news of the Omicron variant is likely to be a short-term, knee-jerk reaction that will unlikely be the end of the current cycle of economic expansion. But the unknown surrounding the new variant is likely to keep investors on their toes and keep volatility heightened.
PORTFOLIO ADJUSTMENTS
We have affected a few allocation adjustments over the past two months in an effort to keep more capital allocated the more productive, higher relative strength areas of the market. The most notable of which has been shifting capital from the value and blend space to growth and from smaller companies to larger companies, which has generally been appreciating more than the broad market on up days and declining less on down days.
In October we rotated our factor model from QUAL (higher quality companies) to Size (bias towards smaller companies). In November we rotated from SIZE to MTUM (momentum, which since the June re-constitution has leaned more towards cyclical/value), then from MTUM back to QUAL as the value trade once again stalled out. We continue to hold QUAL and are comforted during periods of increased volatility when lower debt ridden, more financially stable, higher cash flow companies may not be so quick to be sold during periods of market turbulence and investor uncertainty.
Also, in October we shifted from Growth/RPG to Blend/VV then back to RPG in mid-November as growth re-emerged as market leadership. Moving back to RPG is keeping us overweight in growth, which has been the more consistently productive side of the style box notwithstanding some growth shocks here and there due to the occasional period where yields spike higher.
We are still maintaining our smaller value positions in FAB (multi-cap value) and XLF (financials) which help reduce the effect of those days when growth sells off.
LOOKING AHEAD
As we look toward closing out a productive year, we are very mindful of the crossroads that lie ahead. While the Fed is expected to pare back its pandemic-induced bond buying liquidity programs, and to start increasing the fed funds rate by the middle of 2022, the market is still sorting out the expected pace of rate increases. Historically speaking, initial rate increases have not overly concerned the financial markets, and in our opinion, the economy is on solid enough footing to be able to withstand higher rates. What the Fed will likely do (as it has in past cycles) is to raise rates too much, causing the markets to severely discount future earnings. If the Fed takes their rate normalization program too far, this is still at least a couple years out, and should not be reason for immediate concern. In the meantime, we believe that the late November/early December pullback does set the stage nicely for a year end “Santa” rally, which may lift the markets back to new all-time highs by January 1.
We wish you a wonderful, peaceful, and fun holiday season and a prosperous New Year!
