September saw the first real signs of weakness in the stock markets this year.  While the S&P 500 did not experience a 5% correction, many of the companies within the US market did experience corrections of 5% to 10% or more.  During times of correction, investors often search for reasons as to why markets are selling off.  While we never know with full accuracy why markets sell off (nor exactly when), the recent concerns include: a Chinese property company and contagion concerns, fears around the proliferation of COVID, inflation, a rapid increase in interest rates, an uncertain path regarding a US infrastructure bill package, and a potential government shutdown.    

Stock markets across the globe declined in September.  The S&P 500 broke a seven-month streak of gains after falling by 4.65% in the month.  US small cap stocks fared slightly better than their large cap counterparts but were also down 2.95% in September.  Lastly, international stocks declined during the month as fears around Chinese property development company Evergrande spurred a sell off in global stocks.     

Bond performance also declined as long-term US interest rates rose during the month.  The US Federal Reserve elected to keep the Fed Funds rate unchanged, but commentary regarding tapering (reducing their level of bond purchases) combined with economic inflation data sent long-term rates from 1.31% to 1.52% by month end.  Despite the current rise in rates, real yields (treasury yields minus the inflation rate) remain near 20-year lows.     

As we think about trends in the market, one thing remains consistent: investors always have something to fear.  Political influences, contagion effects of a business gone awry, or simply that markets have worked “too well” are fears that will always be part of investing.  Further, markets rarely move up in a straight line.  The environment we experienced earlier in the year, with seven months of positive performance, is the exception rather than the rule.  Market growth is rarely linear and trying to time the ebbs and flows perfectly usually leads to performance erosion rather than performance improvement.

At Gradient, we focus our decision making on longer term trends in economic and business fundamentals.  We concentrate on trends in global economies, trends in the companies within those economies, and the valuation (what we pay) for those companies.  Using this information as guideposts, over time, is what adds value to an investment process. 

In that regard, the fundamentals keep us positive on the overall condition of our economy and the potential for continued stock performance.  Both US and global economies are growing, and while inflation is a concern, we aren’t in red flag territory as of yet.  The best measures of company performance are revenue and earnings growth.  These metrics have been consistently exceeding expectations and S&P 500 earnings growth is expected to grow at an average of 25% this and next year.  On the other side, valuations are not cheap.  What we pay for stocks in the S&P 500 are at a premium to their long-term averages.  While this is worth monitoring, we feel that higher valuations are justified based on continued low interest rates combined with an economy and businesses that should continue to grow at a higher than average rate. 

These same fundamentals are what keep us cautious on the bond market.  Historically, what investors receive for interest income at the beginning has been a good indicator of bond performance over the subsequent years.  Currently, 10-year US Treasury rates are below the current inflation rate.  Further, default spreads (the premium received for taking on default risk) are near record lows, which means both investment grade and high yield bonds are paying very low yield compared to long term history.  While bonds can still have a place in client portfolios, the environment would suggest very low rates of return for bond allocations until rates rise to levels that make income more attractive.   

Lastly, the investment philosophy of Gradient has always been to do the homework upfront.  We understand the unique circumstances of each of our investors and build investment plans around personal investment objectives and tolerance for risk.  Adherence to the plan, in both good times and bad, are the bedrock of growing assets over time but also protecting assets when markets suffer an inevitable, but temporary, decline.  The world will always give us something to worry about, and those concerns are valid and worth monitoring.  These concerns, however, often lead to greater value for investors who have a plan and can be opportunistic when others are fearful. 

To expand on these Market Commentaries or to discuss any of our investment portfolios, please do not hesitate to reach out to us at 775-674-2222

When reflecting on the markets during the first half of 2021, it is important to understand both where we are and where we were at this point last year.  To be clear, we are not completely done with COVID as a concern, but the data continues to trend positively, and recovery is no longer imminent but is here and now.

As the stock market tends to be a forward-looking mechanism, prices reflected an economic recovery well before it actually occurred.  Over the last 12 months, US large cap stocks are up over 40%, US small cap stocks have increased over 60%, international developed are up over 30%, and emerging markets have risen by over 40%.  We are believers in fundamentals – including the health of the economy and company earnings growth – as the primary drivers of markets over the long term.  With a significant rebound in GDP, strong jobs growth, and corporate earnings that are exceeding expectations by record levels, there is no doubt that the fundamental factors have been as strong as they have been in a long time. 

The strength of market performance that has happened recently often comes with concerns about the future.  The primary point of concern so far has been inflation.  There is little doubt that inflation is present as a result of recovery-influenced demand and continued constraints on supply as a result of COVID.  Certain pockets of extreme price increases (examples being lumber and copper) have been used as talking points for whether inflation is overheated and if the US Federal Reserve needs to change course to control rising prices.  It is our expectation that inflation will remain elevated for the remainder of the year, but we don’t see a reoccurrence of the high levels of inflation witnessed in the 1980’s. 

One of the surprising occurrences of the first half of 2021 has been the direction of long-term interest rates.  It was both the consensus and our expectations that rates would rise this year as a result of economic recovery.  This has been proven accurate thus far as the US 10-year Treasury rate has risen from 0.93% at the end of 2020 to 1.45% at the end of June.  What has been surprising is the direction of rates in the second quarter.  The 10-year Treasury rate crested at 1.74% on March 19^th but has subsequently fallen despite data showing continued economic growth and rising inflation.  These are typically catalysts for rates to rise, and as we expect these economic trends to continue, our stance remains that long term rates are more likely to rise than fall in the second half of 2021.

As we enter into the second half of the year, questions about what drives markets forward are changing as well.  We are less driven by COVID related data, and absent an unforeseen change in trend, we wouldn’t expect COVID to be the primary concern going forward.  The new questions for the markets are now more focused on classic concerns regarding economic growth trends, company earnings and outlooks, the trend of interest rates, and subsequent actions by the Federal Reserve. 

Again, our examination of the long-term direction of the market is based upon fundamentals.  Our opinion is that fundamentals will remain strong as the economy continues to be driven by the resumption of activity by the very powerful and quite healthy US consumer.  This tends to be favorable to continued market expansion.  However, this does not mean the market won’t face difficult times or avoid corrections.  Progression higher in the markets is rarely smooth and steady.  There are often choppy waters even as the direction remains on track.  Corrections should be planned for and expected.  Volatility will return at some point.  We cannot tell exactly what will cause this beforehand nor when it will occur, but the history of markets suggests this is a near certainty. 

Despite the potential resumption of volatility in the markets, our long-term investment approach remains steadfast.  Stay invested for the long term, have an investment plan that incorporates both safe and growth assets, and remain nimble to market changes and future opportunities. 

Stocks have been strong in 2021 across nearly all regions and sectors.  As markets have hovered around all-time highs, one prevalent trend is value stocks outperforming growth stocks.  The S&P 500 Value ETF (IVE) has returned 17.63% in 2021 while the S&P 500 Growth ETF (IVW) has returned 8.19%.   This trend is relatively new, as the 3-year annualized performance of growth stocks at 20.9% still far exceeds that of value at 13.6%.  Much of the value stock outperformance has derived from the higher degree of “recovery” based stocks in cyclical sectors like financials, energy, industrials, and materials compared to the heavy technology weighting in the growth universe.  Whether this trend is sustainable will largely depend on technology stock performance and the valuation investors are willing to pay for the large companies in that sector.    

Long-term interest rates have been trending slightly downward, with the 10-year US Treasury rate ending May at 1.58% after peaking at 1.74% in March.  Short term rates, which are much more controlled by the Federal Reserve, remain at or near zero.  As we go through the remainder of the year, job growth and inflation rates will be significant determinants of long-term interest rate trends, and our opinion is that economic data would suggest higher rates later in the year.  The Federal Reserve has given several indications of allowing inflation to remain elevated in the near term to ensure the economic recovery is on solid footing.  Further, no Fed actions to slow or curb either inflation or growth have been enacted as of yet. 

As we begin to enter the summer months, much of the market analysis will be focused on the economic ramifications of loosening restrictions and the resumption of “normal” activity for a broad swath of US citizens.  Vaccination levels have increased, with recent reports suggesting over 50% of US adults have now been vaccinated paired with a current administration target of 70% with at least one dose by the Fourth of July.  Vaccination data varies across the states and expected future COVID impacts are likely to be more targeted and regional compared to countrywide as seen in the recent past. 

Further, the end of June will reflect the end of the second quarter in 2021, which also provides an anniversary of the most significant economic shutdowns due to COVID.  After this quarter, company earnings and the economy will begin to compare against recovery instead of shutdown, and company outlooks for the second half will give investors a better sense of the magnitude of economic acceleration.

As we stated last month, markets have been incredibly resilient after the severe correction of March 2020.  There have been very few instances of corrections during this time even as economic data has been more uneven.  We are clearly in economic growth mode, but despite inflation concerns as a result of capacity constraints and high demand, investors have been steadfast in buying the slightest of market dips. 

These types of markets rarely last forever.  Enjoy them while they happen but understand that volatility is a function of the market and will return at some point in the future.  This will invariably create a correction as new worries replace the old fears that either subsided or have been concluded.  This is natural and part of the investing process.  Timing this change in trend with an all in/all out strategy is incredibly difficult to do and not recommended.  While we do emphasize prudence over aggression at this time, we believe market fundamentals are on solid ground and would look to market corrections as future opportunities.