The danger months are here
Equity markets marched higher in August, closing at or near record highs on many indexes. The S&P 500 finished higher for the seventh straight month as equity markets continue to climb the proverbial wall of worry.
Entering the month of August, investors were concerned about the dramatic uptick in virus numbers, whether the FOMC (the rate-setting Federal Open Market Committee of the U.S. Federal Reserve Board) would begin the taper too soon, and if we had reached the peak of everything. A month later, while concerns remain around the pace of the economic expansion continuing, worries about the FOMC and virus appear to have faded away in the eyes of investors.
The narrative around the virus has evolved from a widespread fear to a pandemic of the unvaccinated. As such, industries that had been more susceptible to lockdowns and restrictions have been better able to withstand the headlines. The reopening of the global economy, which was never going to be smooth or quick, appears to remain on track, which should be a longer-term positive for the cyclical sectors.
The FOMC was able to calm markets with near-perfect messaging from Chair Jay Powell during the Jackson Hole meetings. Concerns around the timing of stimulus removal have weighed on investors concerned about a repeat of the 2013 Taper Tantrum. Although the employment and inflation conditions necessary for the FOMC to begin the removal of stimulus have been met, the FOMC has signalled that they are in no rush and will not do anything drastic to affect the market.
As long as the FOMC doesn’t take away the punch bowl too soon, conditions remain in place for the bull market to continue. It’s also important to remember that “tapering” isn’t “tightening.” Reducing bond buying may increase bond yields to some degree, but it is very different from an actual rate increase, which continues to appear years away.
Mega-cap technology stocks, which had spent most of the year lagging the market as rates increased, joined the party in August. Whether this is a case of cautious investors viewing them as the “new defensive” sector given their pristine balance sheets, as long as bond yields don’t spike higher, technology should be a core part of investor portfolios.
The real concern investors will face for the next few months will be if we have hit “peak everything.” As much as the market cheered on the peak in the fourth wave and the dovish words from the FOMC, the fact remains that the times of easy money and free flowing stimulus are coming closer to an end. Once these programs end, we will see if the economy is strong enough to stand on its own or if economic indicators begin to roll over.
The most recent corporate earnings season gave investors a taste of this fear, as while most companies reported strong quarters and beats, in many cases, the stocks responded with a shrug. If markets don’t appreciate strong numbers now, what will happen once the earnings growth begins to slow in the face of more difficult year-over-year comparisons? Could this be the fear that hurts markets as we enter the seasonally weak September and October period?
With markets at all-time highs, many investors complacent, and valuations near historic levels, the risk/reward trade-off may not be ideal. Sector rotation has helped to keep the market at all-time highs and it may continue to do, but markets are becoming increasingly narrow and many sectors have had their runs.
By no means does this mean the bull market is ending and a bear market is upon us, but, it could mean that investors should prepare for a change in tone. As we enter the danger months of September and October, the virus peaking could coincide with the peak in economic growth.
There hasn’t been a 5% correction in the S&P 500 in almost a year. Any pullback should be looked at as a buying opportunity as conditions remain favourable for equities and risk assets into year end, but at this time, being defensive and having some risk-managed solutions may allow for a more comfortable ride through the volatility.
Greg Taylor, CFA, is the Chief Investment Officer of Purpose Investments Inc.
Notes and disclaimer
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All data sourced from Bloomberg unless otherwise noted.
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