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The Brave Report: Market Commentary for August 2021

Click here for .pdf version of this report: The Brave Report-August 2021

Ho Hum. Another month, another month of gains… The markets just continue to grind higher with the S&P and Dow notching their 6th straight month of gains. Since the Covid lows of last March, the S&P has been positive 13 out of 16 months. We seem to be in an environment where any short-term weakness is quickly bought, and bad news tends to only last for a few days before investors move on. Recent earnings results have helped to justify some of this upward momentum but with Covid cases again on the rise and several companies issuing more cautious guidance than last year some questions still remain. How long can this continue? And will it end with just a period of consolidation or a more severe correction?

Market Overview

All three major indices climbed higher over the past month. The Dow and the S&P gained 1.2% and 2.2% respectively while the NASDAQ lagged but still gained 0.7%. After the substantial outperformance by the NASDAQ coming out of the pandemic last year, this year has seen much more correlated performance across all the indices, with year-to-date performance remaining within a couple of percentage points.  With the resurgence of virus cases over the last few weeks, it will be interesting to see if we start to see any rotation back to some of the tech or stay-at-home names that outperformed during the pandemic.

On the fixed-income side, we saw an acceleration of a trend that has been in place since the end of March, with rates dropping rapidly across the board. The yield on the 10-year treasury dropped around 40 basis points from the end of June, marking one of the fastest drops we have seen since the beginning of the pandemic. Rates seem to have leveled out near the end of the month but with continued uncertainty around the virus resurgence and questions still remaining about the pace of inflation, this will be an important barometer to keep an eye on in terms of risk appetite.

With markets continuing to surge higher we were watching earnings closely this quarter to see if these moves are justified. As a whole, earnings have been great this quarter with almost 80% of companies beating earnings expectations. However, just looking at the beat rate doesn’t give the full picture of the quality of earnings this quarter.  It is important to look back at what was happening a year ago to understand what is impacting earnings and revenue growth rates.

During the 2nd quarter of 2020, we were in the epicenter of pandemic lockdowns which had a unique impact on each company’s economic results.  Some sectors saw revenue and earnings drop drastically as businesses were shut down and people were stuck in their homes. While other sectors saw revenues surge due to the same reasons.  As we unpack this quarter’s earnings, it is important to factor in the starting point last year for current growth rates and also understand which revenue and earnings changes were just one-time blips and which were long-term trends.

This has been very apparent as we have gotten earnings guidance from some of the companies that saw massive growth during the pandemic.  Some of the large tech names and other stay-at-home names have issued much more conservative guidance than the street expected as they acknowledge that the growth rates they have seen over the past year are not completely sustainable moving forward. With such a surge in revenue for these companies during the pandemic, future growth rates have to come down since growth is measured on a year-over-year basis. Now, I’m not saying that these companies aren’t and can’t continue to grow at very strong rates, on a historical basis.  But we may see growth rates revert back to more traditional levels.

On the other side, the more economically sensitive sectors that lost a lot of revenue during the pandemic should continue to see strong growth rates for another quarter or two since they are growing from such a low base.

While earnings have been great, we are also starting to see a resurgence of virus cases and hospitalizations as the more contagious Delta variant spreads quickly, especially in under-vaccinated areas of the country.  It will be important to watch the impacts of this surge closely.  So far, the major surges have occurred in those states that took a much more liberal approach to pandemic restrictions the first time around so I do not expect them to implement too many new restrictions.  If this surge continues in other areas of the country though we could start to see an increase in restrictions.

I doubt we will see the type of restrictions we were seeing last year but there could be an impact on consumer behavior as people revert back to some of their pandemic habits. We have already started to see this in the business world as many companies have pushed back the dates that they require workers to come back to the office. This would have a positive impact on some of those stay-at-home type names that benefited so much during the pandemic. Technology and e-commerce names could also see a surge as people continue to work from home and limit some of their social interactions.

Another interesting trend we have seen over the past few months is the massive underperformance of emerging markets. This has been driven primarily by weakness in the Chinese markets as the government has cracked down on monopolistic behavior and increased regulation of their big tech names.  While this has drastically increased risk in the region, it has also created a potential opportunity as valuations have reached levels that may make some of this risk worth it for the long-term investor.  I am not saying to go out and put all of your money in emerging markets names but we are reaching a point where opportunities may exist.  I will be watching closely to potentially add to some high-quality names in the region.  Political and regulatory risk will continue to keep these areas highly volatile but the long-term growth story in China and some other emerging markets is still intact.

Strategy Commentary

I have been reluctant to make any large-scale allocation changes in recent months.  Economic data continues to be strong across the board but risks still exist with the resurgence of virus cases.  I am still not quite to a full equity allocation and have been waiting for a pullback to add any new equity positions but this has yet to happen.  If we do see any sort of prolonged consolidation or pullback, I will use that weakness as an opportunity to add back to a full equity allocation.

Domestically, I have maintained my overweight to technology, while this has lagged a bit this year I expect to see a bit of a rotation back into some of these names as their earnings continue to be stellar and the increase in covid cases returns people to some of their pandemic habits.  With it looking likely that a new infrastructure deal will get done sometime soon I will be watching closely to see what the final deal looks like as this could have a major impact on some sectors.

I have not adjusted my international allocation at all recently and have been a bit under-allocated to most regions.  As I mentioned above, I am starting to selectively look at some emerging markets names.  Valuations have reached a level that is very difficult to ignore and although risk remains high, we are now in a zone where building a long-term position could pay huge dividends. I am not going to go out and build a full position right away but will cautiously look to add to high-quality names whose long-term growth prospects remain intact.

With rates dropping rapidly in recent months I have missed out on some potential gains in the fixed income space. However, with inflation still being a concern I am still comfortable holding more cash and missing out on any future rate drops across the fixed income complex.  For me, the risk of rising rates is too great to justify adding to my allocation right now.

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