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Market Commentary: It’s been a long time since a pullback
Investors had a difficult time in September as a robust market rally that began over one year ago finally took a pause. The S&P 500 Index fell 5% from its highs, ending a streak of 227 days without a 5% correction. This was the eighth longest streak the Index went without a 5% decline since 1928. Of course, those who own individual stocks experienced a much greater fall: pandemic-darlings Zoom and Teladoc are 50% below their highs, and many other small, international, and cyclical companies have experienced 20% declines this year.
Current stock market volatility is in part due to a recent rise in interest rates, which has hit the shares of technology companies that have driven major indexes higher for years. Low interest rates encourage investors to pay more for high-growth stocks and have led to historically high valuations for these companies. As of September 30, the top ten stocks in the S&P 500 Index had a P/E ratio of nearly 30, 150% higher than their long-term average of 19.7. Recall that these top ten stocks (which include the likes of Apple, Microsoft, Amazon, and Facebook) make up nearly 30% of the entire Index. A continued reversal of higher interest rates would likely cause investors to question these sky-high valuations.
The economy is now facing a fiscal drag—a negative impact on GDP growth—from the expiration of pandemic spending and support programs which boosted growth over the past several quarters. The Fed lowered its median GDP growth forecast for 2021 to 5.9%, from 7.0% in June, citing Delta-driven shutdowns and supply-chain bottlenecks (e.g., semiconductor and shipping container shortages). At the same time, the Fed sharply increased its median core inflation forecast for this year to 3.7%, up from 3.0% in June.
Although economic growth rates slowed in the third quarter, they are still well above trend, and the near-term risk of recession remains low, absent the always-present possibility of an exogenous shock. As long as the global economic cycle still has legs, we would expect any tighter-than-expected Fed policy to cause at worst a stock market correction—setting the stage for a further market rally, rather than a full-on bear market.
Throughout 2021, S&P 500 earnings repeatedly and spectacularly beat consensus expectations, driving the U.S. market Index to one new high after another. But as is the nature of financial market cycles, excessive optimism can set the stage for disappointment. The higher the expectations/valuations, the bigger the downside risk if those expectations are not met. This dynamic is why a “mid-cycle” market correction is common during this phase of the economic and earnings cycles.
Market corrections are going to happen whether you know the reason, or you do not. It is impossible to predict the timing or depth of market pullbacks in advance. What you can do is realign your portfolio or your expectations. You can learn to live with volatility or make your portfolio durable enough to withstand bouts of instability. Of course, these choices directly related, as without risk there can be no reward.
Our portfolios remain well-diversified across a range of global asset classes and risk exposures, each of which has different risk/return expectation based on your personal needs. We believe the portfolios are positioned to generate relatively strong returns in a scenario of continued global economic recovery with moderately rising interest rates and inflation, even with potentially decelerating growth in the United States. Balanced portfolios should also prove resilient in the event of a negative scenario such as a growth or inflation scare.