, , ,

The Brave Report: Market Commentary for October 2021

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

I thought the market only goes up…..  We finally got a pause in the market’s climb as all major indexes pulled back, registering their worst month since March 2020.  Rising rates, uncertainties over the Fed, a looming debt ceiling crisis and supply chain woes forced investors to de-risk and bank some of their YTD profits.  The fundamentals of the economy still remain strong but after a long run off the pandemic lows, it was finally time for some profit-taking and a reassessment of what is next.  While these uncertainties will continue to lead to some volatility in the markets, we are entering earnings season where we should get some color as to how any of these uncertainties are impacting corporate America.

I do think valuations have been stretched in some areas of the market, so a pause is very healthy. However, even with the overall indices performing well throughout the summer, there are some areas that have already seen some prolonged consolidation and a more substantial pullback. These are the names that should lead the markets higher once investors get more comfortable with the risks that are present.

Market Overview

The markets finally stopped to take a breath. After posting seven straight positive months, markets finally pulled back during the month of September.  All three major indices saw weakness throughout the month with the NASDAQ losing more than 5% with the DOW and the S&P 500 close behind, losing 4.2% and 4.7% respectively. This marked one of the worst months markets have seen since the pandemic. With that said, it basically gives up the gains we saw during the summer and brings us back to where we were in July.

On the fixed-income side, rates were stable for the first three weeks of the month but spiked sharply to close out the month.  The yield on the 10-year Treasury jumped from 1.30% to 1.50 over the course of 3 sessions.  The spike in rates added some fuel to the late month selling in the stock markets but rates still remain well below the high yields of the year that we experienced back in March.  With the Fed signaling a reduction in their asset purchases it is not surprising that we saw rates rise.  It will be important to watch how much of these Fed changes are already priced in or if we will see another spike in rates when they actually implement their rollback of buying.

While this weakness in the markets hasn’t been the norm this year and we have seen CNBC parade all the “the world is ending” crowd across the TV it is important to put this small pullback into perspective.  Even with the weakness over the past month, the S&P 500 still finished September up more than 16% on the year.  With that said, this provides us a chance to assess what caused this pullback and see if any of those risks may carry through for the rest of the year or if they are temporary.

With the run that the market has been on this year, it was inevitable that at some point some increased risk would present itself and we would see some profit-taking.  In this case, a few uncertainties have popped up and rather than see how they played out, a lot of investors just decided to de-risk their portfolios a bit and book some profits while we wait for the next catalyst.  This is normal and healthy for the markets and happens quite often during sustained bull markets.

Now, it is important to point out that I am not trying to downplay any of the risks that are currently present because all of them do have the potential to negatively impact valuations and economic performance.  The big question is to what extent will this impact be felt and how long will they last?

  • Debt Limit:  Unless Congress passes some new legislation, the government will hit its debt limit in the next two weeks. If this happens it could have ripple effects across the entire economy.  Besides its impact on government workers, this would also have a major impact on the creditworthiness of the US. Especially if the government is forced to default on any obligations. At this point, it looks like a temporary deal will be struck but this means the can has just been kicked down the road.  This risk will linger for a few more months until something of substance has hopefully passed.
  • Fed Policy: The Fed announced at their last meeting that they would begin to reduce their levels of asset purchases sometime in the next few months.  This reduction of liquidity in the system puts upward pressure on rates. This move is something that everyone knew would happen at some point so it is not a surprise. For the long-term health of the economy, I think it is a good thing because it shows that this increased intervention is no longer needed.  It signals that the economy is strong enough on its own to not need the Fed backstop anymore.  With that said, the Fed has not fully signaled if/when they will increase interest rates but this is the first step in that direction.
  • Rising Rates: Following the Fed’s announcement we saw a sharp jump in rates and the stock market reacted by selling off high multiple stocks (mostly in the tech space). I have covered the reasoning behind this in previous reports so I won’t do a deep dive into the justification behind this selling.  But, it is important to point out that even with the jump in rates we are still at historically low levels and not even back to the high rates for the year that we saw in the spring.  The selling pressure we see when rates rise seems more like a knee-jerk reaction or something that is more algo driven.  Until we see rates rise to a level that would have a negative impact on company fundamentals then I think this is a buying opportunity in those stocks that have solid balance sheets and trade at reasonable multiples.  I am looking mostly at the big tech names that often get sold off with the high momentum names whenever rates rise.
  • Supply chain issues: Coming through the pandemic we have also seen a lot of bottlenecks in the supply chain across the globe.  This has and will continue to have a negative impact on corporate results in the short term and will be something to monitor closely during upcoming earnings calls.  I think these supply chain issues will be transitory but the longer these bottlenecks exist the deeper the impact becomes and there could be some sectors that see a material impact to their earnings results.

While these risks could all have a negative impact on the markets, the underlying fundamentals of the economy are still quite strong. With the run the markets have been on over the past year-plus, we may need another catalyst before we can take the next leg higher.  As we enter earnings season, we will get some additional color as to how these risks are playing out in the corporate world.  The question will be, are earnings enough of a catalyst to trigger a rally into year-end or will this quarter’s earnings just be a justification of current valuations?  If some of these risks can abate, I think it could be a catalyst, especially with the weakness we have seen over the past month.  However, if any of these risks intensify, I would not be surprised to see continued choppiness, consolidation and profit-taking as investors try to bank what has already been a good year.

Strategy Commentary

I have continued to maintain my equity exposure slightly below full.  I continue to be bullish over the medium and long-term as overall fundamentals remain strong, both for the economy and on the company level.  I think the panic over rising rates is a little overdone at this point and until we see a more substantial rise in rates, I see no reason markets can’t resume their upward march. However, in the short run, I think we will see some continued consolidation and volatility while investors digest earnings over the next month and get a better picture of how aggressive the Fed will be at tightening.  I am comfortable being patient.  I will look to add to my equity positions on any considerable weakness but am in no rush as I think the short-term risk-reward profile looks muted.

Domestically, I have maintained my overweight to technology, and I think the rate induced selloff we have seen is a bit of an overreaction, especially for large tech whose multiples are not that bloated as some would have you think.  I have been hesitant to add to any other specific sectors until we get some more clarity about the Fed’s next move and some more certainty around the pending infrastructure bill.  The small equity additions I have made have been more size and style-based and not sector-specific.  The weakness we have seen has given me a chance to round out any holes in my allocations, but these additions have only been around the margins.

Internationally, I have made very few moves in recent months.  Weakness in China continues to drag on emerging markets and although there continues to be regulatory risk, there becomes a point when valuations become too low that you just have to plug your nose and add to some positions.  There will definitely be some continued volatility but for the long-term investor, these low valuations are difficult to ignore.  If I make any additions, it will only be to the high-quality large-cap names with solid balance sheets.

With rates rising, I have continued to maintain my extra cash allocations as a replacement for some of my fixed income positions.  The risk of continued upward rate pressure as the Fed reduces its asset purchases only adds conviction to this position.