Market Update October 2021 – Correction or Rotation?

CAPITAL MARKETS

Following the March 2020 COVID-induced sell-off, the recovery has been, in many ways, much more orderly than the consensus had suspected.  Undoubtedly, the high level of uncertainty initially kept investors on edge, cautious and concerned that that the March 2020 low may not be the bottom.  As the recovery began to take shape, the early reversal was accompanied with short-lived episodes of declines between five and ten percent through October 2020.  But then markets moved into gear.  Whether it was due to improving (yet still disrupted) social and business conditions, or unprecedented monetary and fiscal stimulus, volatility receded and off the market went to eventually make new highs. 

Looking back, what had initially seemed to be a highly unlikely scenario for equity markets began to fall into place as an unusually lengthy period of low-volatility gains emerged.  For the ten months from November 2020 through August 2021, the S&P 500 Index rose over 1200 points, nearly a 40% gain, all without a single pullback of 5% or greater.  In hindsight, investors experienced a period with business conditions, earnings expectations and sentiment so beaten down that reported results and future expectations faced a low bar for delivering the unexpected positive surprises.  Certainly, there were flare-ups of concern during this period.  But with asset prices already factoring in bad news, the market climbed the “wall of worry” with only short-lived pauses in the broader trend upward.

But why recount the last 18 months now?  Through September 2021 and into October the era without a pullback of 5% or greater has ended.  And why now?  By all accounts, the global economy is now entering a new chapter.  The market’s “recovery” period has made its mark and investors are now contemplating the next phase and new challenges.  With COVID receding and business picking up, interest rates have responded by moving higher.  Add to this a divisive political environment and global supply issues in both goods and services and it’s not surprising that uncertainty is rising on the heels of an era with the bar set low and results (both economic and earnings) tending to come in better than expected.  Can economic conditions maintain their momentum?  (Of course, if the trend was to become more choppy, the history of “seasonality” would bet on it occurring in the September/October time period.)

As we move forward into October, the issues are not new but have changed their complexion.  In the political sphere, how high is the hurdle for providing additional stimulus?  Will global supply chain conditions ease?  If the Federal Reserve is unlikely to raise the fed funds rate in 2021, could longer term rates move higher?  And at what level do rates shift from being “low” to “high”?  For nearly 50 years a 2% ten-year US Treasury had been considered abnormally low.  Today, investors are concerned about rates moving higher towards 2%.

The current, unprecedented monetary and fiscal support has helped the global economy pull out of the virus-driven impediments faced during the prior 18 months.  Now, unwinding these policies will require careful thought and execution as the global economy has shifted from the comfort of this support to the reality that much of it is temporary.  While history tells us that unwinding many of these policies is unlikely to occur in whole, the much-improved economic backdrop should support efforts to begin this process without disrupting the recovery.  And with the current economic momentum, the risk is likely to be found in a policy mistake. 

Uncertainty provides opportunity and, as said above, “markets climb a wall of worry”.  This has been the case since early to mid-2020 and investors will continue to watch for signs of resolution to these events.  Without uncertainty, investor complacency often results in markets getting ahead of themselves.  But barring that, the current reset of asset prices bodes well for another phase of equity market gains to reassert itself.

 

CHART OF INTEREST – Correction or Rotation?

A familiar “battle” in the equity markets pits growth stocks against value stocks and for some time now growth has mostly led, particularly since 2017.  Generally, growth companies do not necessarily need an economic tailwind to perform well, while value stocks typically benefit from stronger economic conditions but may struggle if economic growth is tepid.  Should economic growth pick up, value stocks can respond strongly as their businesses are more leveraged to the economic cycle. 

The tradeoff for growth’s advantage is the premium paid relative to the company’s earnings (if there are earnings) which can be expressed by the price-to-earnings ratio (P/E).  For growth stocks, the ability to weather an economic slowdown often results in investors willingness to pay a higher premium for their investment.  Generally, value businesses require an economic tailwind and if investors judge conditions to be healthy, the lower premiums paid often provide a greater opportunity as these companies’ business prospects improve. 

The cycle between these two groups has been evident during the pandemic era.  Growth has led when pandemic uncertainty has been high, with bouts of optimism in late 2020 resulting in a period of value leadership, before turning back to growth in mid-2021.  Where do we stand now?  Looking at recent market activity, what has looked like a modest correction of over 5%, may actually be the beginning of a rotation from growth to value.  The large size of the growth sectors can obscure the rotation, causing the broad market indexes to decline, even while value sectors are holding up better, currently led by the energy sector.

The chart below puts this in a picture.  Looking at large cap (top clip) and small cap (bottom clip) the S&P indices visualize this potential change in trend.  While both growth and value were in decline during the first part of September, value has now separated itself from growth in both instances.  While this has only been in place for less than two weeks, it does coincide with “value friendly” expectations that political disruptions will come to an agreeable conclusion, rising interest rates will be less disruptive in the near term than some have thought, and business and the economy will continue to recover.  Can value continue to take the lead?  It will be worth watching for more than just value’s resurgence.

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