Markets in Review
After two quarters of rising equity markets through the beginning of this year, the third quarter brought increased volatility and flat to negative returns across virtually all sectors. The S&P 500 Index squeezed out a minimal 0.23% gain during the third quarter with significant losses occurring in the month of September. The tech-heavy NASDAQ followed suit, ending the quarter down -0.38% with a -5.31% decline in September, but demonstrated relatively better performance in August. The Dow Jones Industrial Average ended Q3 down -1.91%.
Figure 1: Price Performance through 9/30/2021
Source: Bloomberg
Following the trend seen during the second quarter of 2021, investors continued to rotate out of smaller capitalization companies and into large and mega-cap stocks during the first two months of this quarter. Once again, this was particularly noticeable for value and dividend-based stocks. However, a reversal of that trend began to emerge in September as large-cap growth and momentum stocks took a heavier beating while investors began to target undervalued companies with more upside once again.
The Russell 2000 Index, which includes 2000 of the smallest companies in the market, was down -4.60% in Q3, however its -3.05% drop in September outperformed the S&P 500, DJIA, and NASDAQ for the month. Furthermore, value-based investing, which focuses on buying companies that exhibit quality fundamentals but appear to be undervalued, exhibited similar returns. The Russell 3000 Value Index lost -1.41% for the quarter, however its -3.54% drop in September also outperformed the other three major indices during that period.
As discussed last quarter, although mega-cap growth and technology stocks (like Facebook, Amazon, Apple, Netflix and Google) may still have some upside, they are more overvalued and primed for a correction than other market sectors. We still feel that cyclical and value assets should continue to outperform on a relative basis throughout the ongoing recovery and reopening from the pandemic. The Bloomberg Barclays U.S. Aggregate Index, which includes a broad cross-section of U.S. fixed income assets overall, was basically flat at 0.05% for Q3 although it is still down -1.55% for the year. Shorter term yields, which move in the opposite direction of bond prices, continued to climb this quarter as expectations about inflation and monetary policy changes sent ripples of anxiety through the market.
Volatility is Back as Risks Increase
After pretty calm and steady gains throughout the first half of this year, during September, nervous traders reminded us that volatility is always right around the corner as U.S. equities notched their biggest monthly decline since the pandemic hit in March of 2020.
Risks seemed to pile up quickly amid mounting fears about slowing economic growth, elevated inflation, labor shortages, supply-chain bottlenecks and a potential global energy crisis. On top of that, markets struggled with political turmoil due to a potential U.S. government shutdown, the possibility of default on our sovereign debt, and endless squabbling over expansive tax and spending packages and infrastructure bills. As if that wasn’t enough, new regulatory risks from China and the potential collapse of one of the largest real estate conglomerates in the world rubbed salt in the wounds of traders struggling to find stability.
What Will the Fed Do Now?
In August, St. Louis Federal Reserve Bank President James Bullard said, “The coronavirus pandemic may have pushed the United States into a volatile era of stronger growth and better productivity, but higher interest rates and faster inflation as well.”[i]
Among numerous other speeches and media events by the Fed, his comments were just one signal that the market needs to prepare for more hawkish monetary policy and tapering the massive Quantitative Easing program that has supported the market for over a decade. During the Fed’s recent September meeting, it became clear that the central bank would start by reducing the amount of both U.S. Treasury and Agency Mortgage-Backed bond purchases that it makes.
In Figure 2 below, we have plotted the size of the Fed’s balance sheet over time. If we expanded the chart further back in time, one would see that the Fed held between $500 billion and $1 trillion of assets from 1995 until 2008. Then during the Great Financial Crisis of 2007-2009, the Fed began to buy bonds in the open market to increase money supply, encourage lending and investment, and help lower interest rates across the yield curve. This is known as Quantitative Easing or simply QE. In 2008, the Fed bought so many bonds that it literally doubled the amount of assets on its balance sheet. The program worked well and, along with other monetary and fiscal policy changes, helped prevent the country from entering a full-blown depression. However, as one can see on the chart, the Fed continued to support the economy using its QE program for the next ten years. Many, including us, have questioned whether the Fed went too far for too long, such that fears exist over just what might happen when they stop supporting the economy, and the markets, as they have.
Figure 2: U.S. Federal Reserve Bank Balance Sheet (FARBAST Index)
Source: Bloomberg
Finally, when the pandemic hit in 2020, the central bank went on another buying spree including some corporate bonds on top of the standard U.S. Treasury and Agency MBS security purchases. The result is that the Fed’s balance sheet has now doubled again in just the past 18 months. Once more, it was necessary at the time to shorten the recessionary period, or possibly prevent another depression. However, we are certainly now at a dangerous crossroads and all eyes are on the Fed’s next move.
We now know that the Fed will start reducing its bond purchases in the next few months. This tapering will continue for quite some time which will certainly impact both bond prices and interest rates, along with money supply and liquid as the balance sheet begins to drop.
The other key question is when will the Fed start raising short-term rates directly by increasing the Fed Fund’s target, which is the interest rate at which depository institutions trade federal funds with each other overnight (e.g., banks with excess cash reserves will lend to others and earn interest).
Some investors, and even half of Fed officials still think that the first interest rate hike won’t occur until 2023. However, the other half of Fed officials believe that 2022 will bring one or even two rate hikes. The market is starting to accept that possibility but the recent data regarding price and wage inflation is suggestive that rate hikes could be even sooner, and faster, than the market expects.
Increases in demand are currently outweighing supply as companies complain about shortages in labor, commodities like gas, oil and copper, semiconductors, and other goods. The result is higher prices, or inflation, and if it is not as transitory as people hope, the trend will likely cause the Fed to take action more swiftly than currently expected.
Hope for the Best, Prepare for the Worst
We see great investment opportunities on the horizon. As discussed before, smaller and mid-sized companies along with value-based stocks tend to perform best in a rebounding economy at the beginning of another bull market cycle. Many of the traditional cyclical and value sectors (e.g. energy, financials, industrials, and materials) that have been underperforming for many years recorded strong performance earlier this year and recently appear to be showing strength again relative to their peers.
However, we believe that the most critical step towards investing success is to preserve your capital by minimizing losses during volatile periods. Avoiding the types of portfolio crushing large losses that happened in the past, and will absolutely happen again in the future, allows investors to be well-positioned for this next bull market growth cycle.
Furthermore, limiting future losses may be more important this time around because those losses may be larger than historical norms suggest. We have had unprecedented monetary policy and government support for more than a decade and as the Fed begins to taper its QE program and raise interest rates, we could be in for quite a roller coaster ride even as we head higher over the long run.
[i] https://www.reuters.com/business/hawkish-bullard-sees-more-volatile-economic-regime-emerging-us-2021-08-03/
Unless otherwise indicated, the source for all price and index data used in charts, tables and commentary is Bloomberg.
IMPORTANT INFORMATION
Past performance does not guarantee future results.
The views presented are those of Steven Van Solkema and Don Schreiber, Jr. and should not be construed as personalized investment advice or a solicitation to purchase or sell securities referenced in the Market Commentary. All economic and performance information is historical and not indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product referred to directly or indirectly in this newsletter, will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio. Moreover, you should not assume that any discussion or information provided here serves as the receipt of, or as a substitute for, personalized investment advice from WBI Investments or from any other investment professional. To the extent that you have any questions regarding the applicability of any specific issue discussed to your individual situation, you are encouraged to consult with WBI Investments or the professional advisor of your choosing. All information, including that used to compile charts, is obtained from sources believed to be reliable, but WBI Investments does not guarantee its reliability. Sources for price and index information: Bloomberg (unless otherwise indicated). WBI Investments pays a subscription fee for the use of this and other investment and research tools. WBI Investments and Bloomberg are not affiliated companies.
Our current disclosure statement as set forth on Form ADV Part 2 is available for your review upon request.
WBI managed accounts may own assets and follow investment strategies which cause them to differ materially from the composition and performance of the indices or benchmarks shown on performance or other reports. Because the strategies used in the accounts or portfolios involve active management of a potentially wide range of assets, no widely recognized benchmark is likely to be representative of the performance of any managed account. Widely known indices and/or market indices are shown simply as a reference to familiar investment benchmarks, not because they are, or are likely to become, representative of past or expected managed account performance. Additional risk is associated with international investing, such as currency fluctuation, political and economic uncertainty.
Annualized Rate of Return is the return on an investment over a period other than one year (such as one quarter or two years) multiplied or divided to give a comparable one-year return.
The Dow Jones Industrial Average (DJIA or “The Dow”) is a price-weighted average of 30 of the largest and most significant blue-chip U.S. companies.
The S&P 500 Index is a float-market-cap-weighted average of 500 large-cap U.S. companies in all major sectors.
The NASDAQ Composite Index (NASDAQ) is a market-value weighted index of all common stocks listed on NASDAQ.
The Russell 3000 Index is a float-adjusted market-cap weighted index that includes 3,000 stocks and covers 98% of the U.S. equity investable universe.
The Russell 1000 Index is a float-adjusted market-cap weighted index that includes the largest 1,000 stocks by market-cap of the Russell 3000 Index.
The Russell 2000 Index is a float-adjusted market-cap weighted index that includes the smallest 2,000 stocks by market-cap of the Russell 3000 Index.
The Russell 3000 Value Index uses the value characteristic book-to-price ratio to create a style index based upon the Russell 3000.
The Russell 1000 Value Index uses the value characteristic book-to-price ratio to create a style index based upon the Russell 1000.
The Russell 2000 Value Index uses the value characteristic book-to-price ratio to create a style index based upon the Russell 2000.
The Barclays U.S. Aggregate TR Index is calculated based on the U.S. dollar denominated, investment grade fixed-rate taxable bond market including treasury, government-related, corporate, MBS, ABS and CMBS debt, and includes the performance effect of income earned by securities in the index.
The Barclays Global Aggregate TR Index is calculated based on global investment grade debt from twenty-four local currency markets including treasury, government-related, corporate and securitized fixed-rate bonds from both developed and emerging market issuers and includes the performance effect of income earned by securities in the index.
Comments