Where We Are
In financial markets, October often contains consequential elements of transformation, passage, and change, with its four weeks ranking only ninth out of 12 months in the S&P 500 index’s average percent change (with a gain of +0.4%) over the years from 1928 through 2020. In 2021, the S&P 500’s close on Monday, October 4th (4300.46) finally ushered in a -5.2% correction — the first time the S&P 500 index had fallen as much as -5.0% in almost a year — from its all-time record closing high of 4536.95 reached on Thursday, September 2nd. And also at its October 4th closing of 14255.48, the technology-heavy Nasdaq Composite index had declined -7.3% from its September 7th record closing high of 15374.33.
Beneath the surface of the headline S&P 500 index (which had been up until then held aloft by a handful of mega-cap technology and social media stocks), as of October 4th, a significant amount of price deterioration had already taken place, as depicted in the table below:
It can be seen that, when the stock market‘s closing bell rang on October 4th, 91% of the S&P 500 companies had experienced a correction of at least -10% from their year-to-date high, with the average decline from each member’s respective peak amounting to -17%. Similarly, 90% of the Nasdaq Composite companies had experienced a correction of at least -10% from their year-to-date high, with the average decline from each component’s respective peak amounting to a meaningful -38%. And constituents of the Russell 2000 index of small- and mid-cap companies were not spared, with 98% of the Russell 2000 companies having endured a correction of at least -10% from their year-to-date high, with the average decline from each member’s respective peak amounting to a substantial -34% setback.
And as shown in the nearby chart of Monthly and Year-to-Date price performance, in September, the S&P 500 declined -4.8%, its worst month of the year (and the worst monthly price decline since March 2020, when the S&P 500 fell -12.5%), with the NASDAQ Composite retreating -5.3%, also its worst month of 2021. After declining -3.6% in July and gaining +2.1% in August, the Russell 2000 index of small and mid-cap companies fell -3.1% in September.
Financial Asset Tailwinds
- The +526,000 jobs gains reported by the “Household Survey,” conducted monthly by the U.S. Census Bureau in the Department of Commerce (which reaches self-employed and small family businesses which the Establishment Survey does not);
- The robust revisions of +169,000 to the prior two months of Establishment Survey data;
- The +317,000 September gain in private sector payrolls (shown in the right panel of the charts above);
- A decline in the September unemployment rate (“U-3”) to 4.8% versus 5.2% in August;
- A decline in the underemployment rate (“U-6”) from 8.8% in August to 8.5% in September;
- Week-by-week reductions in the number of Americans filing for initial unemployment claims (a proxy for layoffs) indicating that the number of job openings continues to outpace the number of unemployed workers, with many employers reporting strong demand for workers and difficulties in filling open positions;
- An increase in Average Hourly Earnings (well distributed across wage cohorts and industry sectors) of +0.6% in September, increasing the year-over-year rate to +4.6% (with six-month annualized wage growth coming in at +6.0%);
- A robust increase of +9.6% over the past 12 months in the Aggregate Income Proxy (defined as hours worked x hourly wages = actual total take home pay); and not least, (ix) our expectation of continued employment progress in coming months, driven by strong labor demand, coupled with easing labor supply constraints and improving Covid-19 infection rates.
- Not only the level of yields, but the speed of yield changes;
- Whether financial market participants are confident that Fed policy officials have an adequate understanding of ongoing inflationary pressures; and
- Financial markets’ interpretation of who will be appointed (or reappointed) to the following Fed positions: (a) Fed Chair Jerome Powell — his term as Chair expires in February 2022; (b) Fed Vice Chair Richard Clarida — his term as Vice Chair expires in September 2022; (c) Fed Vice Chair for Supervision Randal Quarles — his term as Vice Chair for Supervision ends in October 2021; (d) Boston Fed President Eric Rosengren — his position has been vacant since September 30th; and (e) Dallas Fed President Robert Kaplan — his position has been vacant since October 8th.
- The September Empire State General Business Conditions index was 34.3, versus 18.3 in August;
- The September Philadelphia Fed Business Outlook index was 30.7, versus 19.4 in August;
- August Retail Sales rose +0.7% month-over- month, versus -1.8% in July and +0.9% in June;
- The August NFIB Small Business Optimism index was 100.1, versus 99.7 in July;
- August Durable Goods Orders rose +1.8% month-over-month (and were up 15 of the previous 16 months) versus +0.5% in July;
- July Home Prices rose +19.7% (the fourth consecutive month in which the rate of home price appreciation set a record);
- August Personal Income grew +0.2% month-over-month versus +0.8% in July, and August Personal Consumption Expenditures gained +0.8% month-over-month versus -0.1% in July;
- September’s ISM-Services index registered an impressive 61.9 versus 61.7 in August; and
- The August Lead Economic Indicators gained +0.9% versus July’s +0.8% and June‘s +0.6%.
- September’s Conference Board Consumer Confidence reading fell to 109.3 versus 115.2 in August, below expectations and suggesting that companies have become more cautious amid concerns about the Delta variant of the coronavirus and the economic outlook;
- August’s construction spending was virtually unchanged versus +0.3% in July, and January through August year-to-date came in at +7.0%, as increased activity in public sector projects was offset by private sector weakness; and
- Economic activity has downshifted in China, the world’s second largest economy, with August’s Industrial Production +5.3% year-over-year versus +6.4% in July, August‘s Retail Sales +2.5% year-over- year versus +8.5% in July, and the January-August year-to-date Fixed Asset Investment +8.9% versus +10.3% in the previous interval.
Our base case view remains that the U.S. economy is continuing on a positive growth trajectory, as the growth rate slows somewhat from the rapid rates of recovery experienced late last year and early this year. Labor shortages, logistical bottlenecks, Delta variant disruptions, and cost pressures have dampened the growth outlook for the second half of 2021, with the shortfall from prior full year growth estimates being partially added to full year GDP growth estimates for 2022. The rebound in private business investment, an important component of helping to ease supply bottlenecks, remains in its early stages and is subject to reductions reflecting the uncertain outlook for final demand. Corporate Profits: During the current 2021 third calendar quarter earnings reporting season, investors need to play close attention to corporate CEOs’ and CFOs’ revenue and earnings comments — with particular focus on: (i) profit margins; (ii) pricing experience (prices paid as well as prices received) for labor, logistics, transportation, and raw materials; and (iii) the forward outlook from economy-sensitive sectors such as airlines, credit card companies, theme parks, cruise lines, restaurants, and numerous other industry groups leveraged to the economic recovery and reopening. Given that a good deal of the anticipated positive profits news may already be reflected in equity valuations, of critical importance in the period ahead will be the magnitude and direction of analysts’ earnings revisions, not only for 4Q21, but also for each quarter and the entirety of calendar year 2022. With year-over-year economic growth projected to slow in the coming calendar year, profits growth in the first half of 2022 is likely to be considerably less robust than in the second half of 2021. Judicious discernment will thus be critical in the selection of sectors, companies, and investment managers. For more of our thinking, please refer in the Portfolio Positioning Tactics section of this Commentary, to “Equity Emphases and De-emphases,” “Focus on Strength and Quality,” and “Balancing Growth and Value Sectors.” Pandemic Attenuation: According to the Centers for Disease Control and Prevention, the U.S. seven-day average of daily new Covid-19 cases (adjusted for holiday anomalies) peaked at 166,105 on September 1st and by October 6th, the seven-day average of daily new Covid-19 cases had fallen -39%, to 101,262. Over the same time frame, hospitalizations declined -30%, and mortalities (which usually change direction a few weeks after cases) had declined -13% from September 20th through October 6th. As the Delta variant of Covid-19 shows signs of receding, over 80% of the total American population has received at least one shot or has reached natural immunity due to having contracted the coronavirus. With 6.8% of the total American population under five years old and thus not vaccinated, in the aggregate, at least 87% of the U.S. population has had a shot, has attained natural immunity, or is under five years of age. Including boosters,
Financial Asset Headwinds
Portfolio Positioning Strategies:
In the current slowing yet still relatively robust economic expansion and upwardly-trending inflation and yields environment, we believe that careful thought, planning, and attention needs to be devoted to the investor’s most appropriate forms and vehicles for implementing the fundamental elements of Asset Allocation and Investment Strategy, which include:
- Diversification: while it doesn’t guarantee a profit or ensure against a loss, diversification means having sustainably low- and negatively-correlated investment exposures that truly counterbalance price movements in other assets, particularly during times of great financial stress and/or market volatility;
- Rebalancing: which encompasses using concepts of reversion to the mean to trim exposures to assets that have grown to represent too large a portion of the overall portfolio, while at the same time, adding exposure to high-quality assets that have fallen out of investor favor and suffered significant, though deemed not permanent, price declines vs. intrinsic value;
- Risk Management: which involves recognizing when markets have become consumed by meme securities, momentum plays, “story stocks,” and information overload — a situation that has pertained in recent experience to more than a few companies in the technology space — and understanding the degree of liquidity, the true pricing realism, and the appropriate roles of short-term liquid securities, real assets, financial assets, and alternative assets in decades-long (or longer) regimes of inflation, stagflation, deflation, monetary disruptions, and currency resets;
- Reinvestment: which encompasses knowing when to emphasize and trade off income return versus capital growth, all the while keeping in mind the critical importance of discipline, equanimity, patience, tax awareness, and longevity in capturing and compounding dividend, coupon, rental, and other income flows; and
- Asset Protection and Husbandry: which encompass considerations of current and likely future income and capital gains taxation at the state, local, federal, and possibly international level; estate planning; relevant insurance design and structuring; cybersecurity shielding; portfolio monitoring and reporting; administrative costs; forms, frequency, and means of asset access; and asset custody.
Portfolio Positioning Principles:
We continue to allocate to a considered and considerable exposure to equities, with judicious shifts between styles, sectors, geographies, and — where appropriate from a cost, timing, tax, liquidity, and size standpoint — public versus private markets. Expressed below are a number of themes that we believe should be taken into consideration over the next few years in selecting asset categories, asset classes, asset managers, sectors, companies, and security types:
- Paying Attention to the Value of Money: Taking advantage of (rather than being taken advantage of by) the likelihood of money printing, internal and external currency debasement, government debt monetization, and the ‘Modern Monetary Theory’ approach that to some degree in the pandemic- response era has been pursued by the Authorities — within shifting money and credit cycles — to service America’s massive explicit government and corporate indebtedness and the enormous implicit obligations of pension and healthcare promises;
- Concentrating on “All-Weather” Sectors and Companies: Seeking investments with balance and flexibility, that are able to thrive regardless of: which political persuasion informs the thinking and policies of the White House, Congress, the nation, and the regulatory authorities; evolving Environmental, Social, and Governance (ESG) priorities and values; wealth distribution initiatives and public health conditions; and wider socioeconomic trends;
- Distinguishing Between Temporary and Permanent Change: Focusing on the commercial and financial implications of new social and political power structures, alliances, and geopolitical relationships; new energy sources and resources; new trade patterns; new on- and offshoring channels; new “WFH” and “WFA” (Work From Home and Work From Anywhere) employment modalities; and new business models, pathways, digitalizations, and forms of person-to-person and business-to-business work, leisure, learning, and wellness activity;
- Taking Advantage of Demographic Tailwinds: Through U.S. and select non-U.S. companies, gaining exposure to, and meeting the rising needs, aspirations, and not overly ostentatious spending power of, the rapidly expanding global middle class, especially in Asia (Please see the nearby chart for data on the past projected growth of the middle class as a percent of the total inhabitants in five large population countries);
- Comprehending and Verifying Past Success: Emphasizing companies and sectors that have demonstrated successful track records and past experience in: competitive preeminence; abundant free cash flow generation; capital allocation; balance sheet strength; risk management; sustainably defendable business models; and the ability to sustain high multiyear returns on equity (derived from revenue growth and favorable margin preservation, rather than through inappropriately high levels of leverage) meaningfully above the companies’ and sectors’ weighted average cost of capital; and
- Identifying Innovative and Disruptive Technology Hegemons: Focusing on technology enablers, disrupters, and dominators in biotechnology, diagnostics and therapeutics based on CRISPR (Clustered Regularly Interspaced Short Palindromic Repeats), weight management and wellbeing, public health, medical nutrition, regenerative medicine, artificial intelligence, data analytics, machine learning, 5G cellular network technology, the Internet of Things, infrastructure, robotics, retraining, quantum computing, battery inventions, alternative energy, electric vehicles, and cybersecurity, while not least, also taking account of the Environmental, Social, and Governance (ESG) risks, aspirations, and initiatives of companies in these and other fields.
- Keeping Things in Perspective: Many of the overarching themes and conditions that influence our intermediate- and long-term asset allocation and investment strategy emphasize the need to recognize that the concepts and implementation methods intended to achieve safety, balance, purchasing power protection, diversification, and liquidity are likely to face evolving (and sometimes, rapidly shifting) taxation regimes, regulatory architectures, social priorities, geopolitical power relationships, price level changes, demographic trends, indebtedness levels, technological penetration and usages, and importantly, perceptions of the definition, role, degree of physicality, embodiment, and value of money itself.
- Flexibility versus Conviction in Formulating Investment Thinking: In seeking to determine when to adhere to, and when to lean against, prevailing consensus views (sometimes pejoratively referred to as “groupthink”), it is important to critically question the soundness and durability of the reasoning and assumptions underlying a given investment framework and positioning at any point in time. While it may not make sense to hold out-of-consensus views just for the sake of doing so — often expressed as “fighting the tape,” — at other times — especially at major cyclical or secular turning points (at a significant asset top, when reality is finally found to fall short of prevailing overly optimistic expectations, or a major asset bottom, when reality is shown to be worth considerably more than prevailing overly pessimistic expectations), the rewards of implementing a contrarian stance can be quite meaningful.
- Enhancing and Preserving: While we admit to a continuing degree of unease over this year’s manifestations of investor exuberance, and the popularity of certain stocks and sectors considered to be “forever holdings” — our short-term inclination at this juncture is to take note of the Federal Reserve’s lessening support of financial asset prices while taking advantage of episodes of strength to continue the course of upgrading positions — offloading lower-quality, higher-risk assets and with timing and price discipline, adding to attractively-priced, higher-quality assets on equity market pullbacks. It is worth keeping in mind that the average year includes three separate -5% or more pullbacks for the S&P 500, with only one transpiring thus far in 2021 (and no -10% correction has taken place thus far since March 2020). With a likely Fed tapering later this year, slowing in China, and view of our expectation of increased volatility in the remainder of 2021, prudence counsels being vigilantly aware of the increasingly narrowing market breadth and taking advantage of such retrenchments before committing significant amounts.
- Equity Emphases and De-emphases: Particularly in the current conditions of rising (even though low, from a historical perspective) U.S. Treasury interest rates, and given the likely focus areas of government spending initiatives, to us it appears likely that cash-generating, financially-stable companies with robust growth prospects, which are able to operate and thrive in the digital sphere as they continue to enhance their business models, deserve to retain some degree of a valuation premium. Within equities: (i) we suggest continuing to gradually shift emphasis from Growth sectors, companies, and managers towards the inclusion of select Value sectors, companies, and managers (with a focus on financials, industrials, materials, Covid-recovery, reopening, and consumer sectors); (ii) we continue to counsel selectively adding small- and mid-cap companies (or investment managers specializing in and with good track records in this space) to our primary yet gradually lessening emphasis on large-capitalization enterprises; and (iii) for the time being, while we continue to prefer a tactical overweighting to U.S. domestic equities — with any pullbacks currently viewed as an opportunity to judiciously add equities, particularly those sectors and companies likely to benefit from an economic recovery —we also espouse holding (or gradually building) relatively modest allocations to emerging market equities and developed international markets.
- Focus on Strength and Quality: Our long-term equity portfolio weightings continue to emphasize asset managers, sectors, and specific companies that can benefit from the major sustained trends of the 2020-2030 decade, including: (i) incremental growth in a wide range of economic circumstances; (ii) a focus on economic repair, digitalization, e-commerce, personal wellness, safety, domesticity, home improvement, infrastructure spending, and sustainable consumer demand; and (iii) advantageous capture of benefits from onshoring, supply chain redesign, and deglobalization as important drivers of capital spending and disruptive innovation. At the company level in equities, we emphasize identifying and building long-term exposure to firms possessing fortress-like, cash-rich balance sheets, prudence in balance sheet utilization, limited debt, consistency and durability of positive free cash flow generation, dividend strength, and competitive business models with sustainable competitive advantages (high barriers to entry, low threat of substitute products, and viable pricing power vis-à-vis suppliers and/or customers) that over a long time frame can generate high returns on equity (as mentioned above in “Comprehending and Verifying Past Success,” through revenue growth and enduring profit margins, rather than through inappropriately high levels of leverage). At the current time, we suggest that consideration be given to top-quality companies in the healthcare, consumer staples, and financial sectors.
- Balancing Growth and Value Sectors: Through Thursday, September 30th, the total return of the Russell 1000 Growth index (including companies in sectors such as technology, healthcare, and communication services) was (according to The Wall Street Journal) +14.3% year-to-date, while the total return of the Russell 1000 Value index (including companies in sectors such as financial, real estate, energy, utility, and industrial businesses) was (according to The Wall Street Journal) +16.1% year-to-date. This 1.8 percentage point (1.8%) Value minus Growth returns differential appears to argue for some degree of balanced exposure in selected Value sectors, companies, and managers as well as selected Growth sectors, companies, and managers. As this process continues, it is worth keeping in mind that true value investing represents identifying assets that are trading for less than they are actually worth, not assets that are merely inexpensive. Many superficially inexpensive assets may very well be inexpensive for a reason, and can very well remain so or deteriorate further.
- Fixed Income Securities: Bond prices persist at elevated price levels, with ultralow yields across the maturity spectrum; even though yield movements have been modest in the past two months, they have risen somewhat since year-end 2020 (with, according to Bloomberg in mid-July, an extraordinary total of $16.5 trillion, up from $12 trillion in mid-May, in global negative-yielding sovereign — and some corporate — debt outstanding). We prefer issuers at the high-quality end of the rating spectrum, both in taxable investment grade and high-yield bonds and in tax-exempt bonds (where we continue to see some pockets of value on a taxable equivalent basis). We see fixed income securities as continuing to be subject to price risk due to our expectation of somewhat higher yields in the fourth quarter of 2021, and thus we prefer maturities and durations along the short-to-intermediate portion of the yield curve spectrum.
- U.S. Dollar Outlook: After declining -9.9% in 2017, appreciating +4.4% in 2018, marginally gaining +0.4% in 2019, and declining -3.4% in 2020, the DXY U.S. dollar index measured versus a basket of six major currencies — the euro, Japanese yen, Swedish krona, British pound, Canadian dollar, and Swiss franc — had as of its market close of 94.23 on September 30th, appreciated +4.8% year-to-date in 2021. Over the next few quarters, we believe the U.S. dollar may begin to trace a gradual path of weakness as — due to the likelihood of other major central banks becoming more assertive in their asset-purchase tapering, combined with the magnitude of the U.S. current account payments deficit.
- Alternative Investments and Real Assets: In alternative investments, we continue our multi-quarter focus that has for some time emphasized exposure to: (i) commodities and real-asset sectors of the economy including industrial metals, agriculture, and materials, (ii) gold and/or gold mining ETFs/shares (particularly those miners with reserves in stable geographic locations, capital discipline, and cash flow growth); (iii) high-quality master limited partnerships with strong business models and sustainable dividend-paying capacity; (iv) select investments in private credit and private real estate; (v) and opportunistic strategies that are positioned to selectively derive meaningful value from the dislocations created by the coronavirus pandemic and the economic and profits recovery that we expect in the year ahead.
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