Q3 2021 Market Commentary
Answers to Our Most Recent Client Questions
US stocks, as seen by the S&P 500, ended the third quarter unchanged, having shed over 4% in September as fears over the debt ceiling and the Fed’s options erased the summer’s progress. Certainly, the market environment has changed a lot over the past 18 months. Valuations are up, economic data is varied, and the prospects of potential Fed action are growing. In this quarter’s commentary, we will try to address the most common questions we are hearing from clients. In general, we advise against extrapolating short-term trends.
Q: The stock market has been strong and valuations are higher, should we remain invested in US equities or prepare for a deeper correction?
A: Valuations are indeed up. However, in our opinion, the change in risk profile of the underlying investment environment is the more important issue that investors should consider. Simplistic multiples-based valuation measures go up and down and can remain elevated for a long time. Understanding the investment backdrop is vital to returns in certain segments of the market.
Recently, the Fed confirmed its intent to reduce the liquidity infused during the pandemic. While the Fed is likely to keep interest rates low, a slowing of bond purchases will tighten monetary conditions and remove the tailwinds behind riskier segments of the market. Thus, high-flying, hype-based story stocks should be avoided as economic realities become more important. There is just too much downside and complacency in these stocks which, unsupported by a sustainable business, have a steep risk profile. Since Oak’s portfolios are very high-quality and constructed with a very long-term time horizon, they are well positioned given the change in the market’s risk profile.
Additionally, a rising tide over the past 18 months has lifted all boats. The loose monetary environment, stimulus efforts, and anticipation of the end of the pandemic propelled stocks. Some sectors, which were struggling (and thus lowly valued) prior to the pandemic, disproportionately benefited from the cyclical recovery. Yet as the economy normalizes, these formerly challenged sectors are likely to struggle and should be avoided. So too should the sectors at the epicenter to the latest crisis. Historically, the victims of the last market crisis may rebound sharply as the emergency abates, but they can then underperform for years. For example, retail stores were struggling prior to Covid and it is doubtful consumers will return to the mall in a post-pandemic world.
As far as predicting the next bear market, timing the market has an extremely destructive impact on long-term wealth creation. It compounds decision-making mistakes and creates unnecessary taxable events. Academic studies have shown that remaining fully invested is significantly more effective in creating long-term wealth than actively trading. In practice, market timing inevitably misses the tail end of a strong bull market out of fear, and then rejoins the next bull market late and with less capital. Our solution to this dilemma is to ensure we hold high quality companies with strong long-term prospects, while trying to avoid emotional decision making, and preparing for market changes through altering risk exposure, sector allocation and valuation tolerance. We prefer to be selective and own quality growth companies, a segment that tends to benefit at this stage of the bull market lifecycle.
Q: Do we agree with the characterization that inflation is transitory or temporary?
A: Recent inflationary pressures are well documented. It has been a textbook case of too much money chasing too few goods. Consumers, eager for a return to normalcy while flush with direct stimulus payments and higher assets values, collided with supply chains constrained by Covid and labor shortages. However, depicting the resulting inflation as transitory is likely too simplistic. A more appropriate characterization is: “it depends”.
Certainly, some price increases will be temporary, others may be one-time adjustments, and some may be more persistent. It is difficult for businesses to claw back wage increases and they are likely to hike prices in response to higher labor expenses. Conversely, more commodity-driven or supply chain problems will be transitory as production and distribution issues are resolved. Overall, a return to economic normalcy should lead to correcting inefficiencies that make inflation better rather than worse.
We continue to see the typical equilibrium mechanisms working as they should to adjust supply/demand dynamics and prices. As a new equilibrium is found, the rate of price changes will slow. Some businesses may have to endure some higher input prices, but competitive pressures are powerful and have typically produced deflation over the long-run. In the meantime, the US economy is also very familiar with certain inflation. For example, both health care and education costs have risen at rates double the CPI for decades.
For further thoughts on inflation, please see our Q3 Presentation.
Q: It seems there is a labor problem, won’t this fuel inflation?
A: The labor market is indeed tight and businesses of all types are finding it difficult to hire workers. Consumption returned faster than the employees needed to meet that demand. However, the actual unemployment rate of 5.93% is a distraction and there is probably more slack in the labor market than it indicates. The US unemployment rate refers to a percent of jobless who looking for work. Yet it fails to account for those that have left the workforce, retired, gone back to school (in person or remotely), can’t work due to childcare issues, or are delaying work due to Covid risks. Additionally, prior immigration policies and pandemic restrictions prevented the free movement of workers which also affected the labor pool. As the pandemic wanes and policies adjust to business needs, workers will be tempted back into the labor force. Again, this is another data point that is likely to get better, rather than worse, as the economy normalizes.
The fact that the economy is somewhat constrained by the shortage of labor and goods could be considered beneficial, if it helps keep the Fed from tightening monetary conditions prematurely. It is a break on economic activity that prevents the engine from overheating. Many industries are also learning to adopt technology to ease the shortage of human capital. You can anticipate seeing more self-checkout lanes at stores and even restaurants soon. A labor shortage may exist today, but it too should adjust.
Q: Will pending changes to income and capital gains taxes thwart the stock market?
A: The stock market has known for about a year that higher taxes were coming, due to a change in Washington. Yet, it has continued to rally to new highs. Stocks are more apolitical than most realize. This is due, in part, because tax rates don’t universally affect all market participants equally. Taxes are also a little bit like the weather, just wait a minute and they might change. Making long-term investment decisions based on tax policy is suboptimal.
A change in the capital gains tax rate may add some short-term volatility to the market once the final rate is negotiated. But again, capital gains taxation is an ex-post transaction levy that only affects certain market participants. If the asset is held in a retirement account, it avoids capital gains taxes. If you earn under a certain amount, you will qualify for a lower rate, etc. Like income tax policies, capital gains rates could also change in the near future. The fact that the rate may rise from 20% to 25%, instead of to the top ordinary income rate, is a minor victory for investors.
As in everything, the devil is in the details and we simply don’t have a final version of tax rate changes yet. Nor is it prudent to make strategy or holding changes impulsively. There is the potential for estate law changes to have inadvertent consequences, but we will continue to monitor the details as they come out.
It is natural to extrapolate recent trends into the future. Yet, problems in the supply chain and labor market are likely to get better rather than worse. The stock market understands this and will look through these constraints. Chatter about the Fed’s response to these issues will add volatility to the market as it evaluates the punch bowl. For now, the low interest rate environment is likely to persist and economic activity will continue to normalize. Disagreements in Washington over funding will get resolved as both parties need to regularly raise the debt ceiling. As always, we will continue to monitor risks in the market.
Robert Stimpson, CFA
Co-Chief Investment Officer
Oak Associates, ltd.