The third quarter started off strong but ended weak. Although, the large cap major market indexes logged modest quarterly advances. The S&P 500 gained .05%, the NASDAQ 1.1%. The Russell 2000 small cap index declined 4.5%. The Growth index (RPG) gained 5.5% while the value index (RPV) shed .5%. The bond index declined .4%
September, a typically weak month, was challenging to say the least. After logging an all time high on September 2nd, the S&P rolled over and declined over 4% as the rest of the month unfolded. Growth was rattled by another bond yield surge, declining 4.5%, while value, catching a bid from the sell off in bonds, declined only .4%.
WHATS DRIVING THE MARKETS
Inflation, supply constraints, the Delta variant and interest rates
Once again, the market movement seemed to be driven by the same concerns as the prior quarter, perhaps a bit more so. Inflation readings continue to come in high, challenging the Fed’s declaration that higher inflation is likely to be ‘transitory.” The longer inflation stays above the Fed’s 2% mandate, the less transitory it will ultimately be, creating additional worry that higher prices may be with us for longer than originally expected.
Part of the reason for recent inflation is from global supply constraints, as manufacturing companies continue to produce at less than capacity, both due to a shortage of workers, but also the slower movement of raw materials and goods as the major shipping ports continue to be backlogged. The consumer, still flush with savings greater than in years past, continues to increase their buying of goods and services, so demand is not the problem. There are simply too may dollars chasing too few goods, causing prices to rise. Some companies are passing those higher input costs on to consumers (Dollar Tree recently announced a price increase from $1 to $1.25), and other companies, like Nike, are claiming that labor and raw material shortages in their Asian facilities are reducing their production capacity, causing a decline in inventory against otherwise robust demand for footwear and clothing. Declining inventories, reduced sales resulting from said manufacturing limitations and higher input costs will likely impact corporate revenues, possibly causing a drag on future earnings. This supply/demand imbalance is unsettling to the market as it digests the impact on corporate profits and thus whether valuations are too high to justify current stock prices.
The Delta variant continues to grab headlines, causing stress in many areas of daily living. As various countries around the world limit mobility to reduce the spread of COVID, many employees are not returning to work (one cause of the labor shortages which in turn causes a reduction in goods produced). With students returning to school and the flu season upon us, people are taking extra precautions and doing less.
Perhaps the largest market mover is the interest rate environment. Just last month when the Fed confirmed its position that raising the Federal Funds rate is still at least a year off, the market is looking ahead to assess the impact of that lift on the economy. We anticipate the Fed to reduce its bond purchase program, as mentioned in our last client note, however we reiterate that reducing their pandemic induced bond purchase program should not have the same impact as interest rate normalization. However, due to the inflation factor and the likely bottoming in interest rates in mid-September, higher rates are putting pressure on growth stocks, as had been the case at the end of the prior quarter. As we saw in the second quarter, the upward velocity in September’s rate movement sent high valuation growth stocks swooning. We don’t think it was due to rates moving higher, but rather the increased pace served as a shock to growth names. Given the S&P500 and the NASDAQ 100 are market capitalization weighted indexes, a sell off in the largest growth names affects the direction of those indexes as the top five largest growth/tech companies make up some 22% and 41% of the S&P 500 and NASDAQ 100 respectively. There are still areas of market strength, such as financials, energy and other economically sensitive areas of the market which tend to do well when rates increase. But the capitalization weight of those sectors are tiny in comparison to the growth-dominant tech sector, so the broad market may continue to be under pressure.
PORTFOLIO CHANGES
There were very little changes to the TWG model portfolios since our July update. In fact, the only adjustments made were early August, where we shifted our growth exposure from the mega tech heavy VUG to RPG, seeking to capitalize on the upward movement of smaller tech, as well as moving back into financials via XLF on August 10th. We currently maintain an overweight to growth but stand ready to shift some of the portfolio to the value or blend side should rates continue to rise and we observe the continued benefit to those economically sensitive areas. Big cap tech took a breather in the late spring/early summer when interest rates moved higher, but as rates stabilized and declined thereafter, mega cap tech resumed its ascent. It was this time that value and cyclicals previously took the baton, but that trend was short lived. We are observing a similar environment playing out, a tug of war if you will between growth and value. Whatever scenario plays out, we have ample tools and flexibility to adjust the portfolios to stay invested in the most productive areas of the market, even when that means being less dependent on mega cap tech, which makes up such a large percentage of the broad market capitalization.
TECHNICAL ANALYSIS
Below is a chart of the S&P 500 and the 50-day MA (purple) and 200-day MA (red). As a refresher, the moving averages is a smoothing mechanism to understand the short term (50 DMA) and longer term (200 DMA) trend lines. As you can see, the 50 DMA has proved to be a good level of support for the market, but it is currently under pressure. This implies that the near-term movement may not be up and to the right. The index will likely bounce above and below the 50-day MA battleground as the impact of higher inflation, higher rates, fed policy and supply constraints get sorted out. The longer-term trend line (200-day MA) is still well below current market price, suggesting that higher prices over a longer time period are likely. Bottom line, the market is still in a long-term uptrend, but the more immediate term trend is less certain.
LOOKING AHEAD
September and October are usually volatile months, and this year is no exception. The proverbial “wall of worry” is a concept that suggests the market needs things to worry about to continue to move higher. Without any worry, the market gets too complacent and risk-taking increases, pushing up valuations to levels that don’t make sense. With enough “worry on the wall,” the market can be kept in check by keeping participants questioning the sustainability of the ascent, thereby moderating the rate of acceleration to the upside, which we consider a healthier, less frothy market environment.
Be that as it may, the current drawdown is still only 5%, nothing out of the ordinary. It may seem more concerning given the market has not seen a 5% pullback in close to a year, but such pullbacks are not only normal and frequent, but they are also necessary for the market to move higher in the months ahead.
We wish you well.
