As we roll into September, it reminds our academically oriented team of "back to school" season and a natural desire to study markets with even more vigor than normal while keeping our pencils sharpened! Given that we are entering a season marked by past market disruptions, this "back-to-school" mentality may come in handy. In general, global equity markets have been generous and pleasantly calm for 15 months straight. We have not even experienced a single 8-10% correction, which is normal for bull markets. Can this era of generous returns and low volatility continue? What would bring about a normal 8-12% correction? Or something worse? These are important questions every investor should consider.
The rally in global equities has had a smooth, upward glide path that makes complete sense when we view it through the lens of business cycle analysis. The COVID-19 recession is abating, and markets have been discounting the fact that a new business cycle has begun. A simple perusal of past business cycles and equity market returns during the first 18 months coming out of any new economic expansion shows us very similar market behavior - generously "up and to the right" with low volatility. This is usually due to massive amounts of money that fled markets during the recession-related bear market and those same investors attempting to re-enter as the economy shows signs of improvement. Coupled with the excessive injection of liquidity by global central banks - including our Federal Reserve – this period is no exception. This combination of forces has created these types of markets in the past and is doing so now once again. However, investors would be foolish to think that this is the future behavior of stock markets going forward.
Our research suggests that we are soon to be entering a part of the business cycle where the economy may continue to recover at a fast rate - but not quite as fast as we have seen in the past 12 months. It is quite common in the initial phases of recovery that the global economy jump-starts and then finds a more sustainable, albeit lower, glide path within 18 months - which is where we are most likely headed. It is also a course which the Federal Reserve would like the economy directed towards as well. Hence their recent suggestions of reduced liquidity and eventual interest rate increases. These transitions in economic growth and Fed policy usually bring about a more volatile stock market as investors tend to get spooked over slightly lower growth and the possibility of the Fed making an error such as raising rates too quickly. However, this transition seldomly leads to the end of a bull market – just a different one. Investors should expect normal 8-12% market swings as we go "up and to the right" and annual returns more in keeping with the historic 10% return on equities. With this in mind, we are tactically rebalancing exposures and temporarily increasing cash levels. We look forward to thoughtfully reinvesting this capital in the near term at attractive valuations as opportunities present themselves.
Stocks are still by far the best game in town! As we enter this possible change in market behavior, we continue to embrace our theory that this is still the early innings of a long business cycle and economic expansion. Of course, if some black swan or COVID variant brings us into an unexpected recession, we will allow our Active Risk Management process to engage in order to mitigate catastrophic decline.
This somewhat different market we envision should still be profitable and create some excellent opportunities in different economic sectors – some of which have been rightfully ignored by investors in this initial post-recession market rally. For instance, as economic growth rates simmer down, the attraction to consistent growth companies will be once again in vogue – think consumer staples and healthcare. As this phase of the market cycle comes to fruition, we will be providing you with more updates – particularly as volatility goes from complacency to normalcy. Many investors have been lulled into thinking that the recent lack of volatility is the "new norm," and they may be in for a rude awakening.
There are many catalysts that could kick-start more normal market volatility. The virus data is certainly one factor, and frankly, our team is a bit surprised that the recent data hasn’t stirred the market even a little. A more likely cause of market volatility may be the Federal Reserve and their realization that left unattended, the current economic growth and inflation rates could cause the economy to overheat. Lastly, we always consider geopolitical risk within the context of our work and how this could be a source of market volatility.
In terms of interest rates, we - along with many high-profile investors - are surprised by the continued low-interest rate environment. Perhaps it’s the bond market’s way of discounting the troubling virus data? If so, when the virus numbers improve, rates are likely to bounce higher – if the Fed doesn’t raise them first. Higher interest rates would make it easier to find value and would create more opportunities for us to add to your individual bond holdings. We look forward to that trend.
As you know, we are bullish despite our increased expectations of volatility. However, should this optimistic view become derailed by one of the factors mentioned above or something else entirely, we stand ready to manage downside risk through our time-tested Active Risk Management process, including the flexibility to reduce your allocation to equity markets, sector management, and the use of carefully placed stop losses.
We hope you find this brief update helpful and if you have any questions about our work or have experienced a significant change in your financial situation, please let us know.
Thanks again for your confidence in our firm!