Commentary | 3Q 2021
2021 Q3 Market Recap
In the third quarter of 2021, the stock market slowed its rise from the lows of early 2020. The market, as represented by the S&P 500 Index, generated a return of 0.6% in the third quarter. Over the year-to-date period the market has returned 15.9 %. Using S&P indexes as benchmarks, large cap growth stocks rose 1.9 % in the quarter, and large cap value stocks fell 0.9%. Small cap stocks declined 2.8% over the same period. On a year-to-date basis small cap returns outpaced large cap returns 20.1% to 15.9%, and large cap growth stocks have returned slightly more than large cap value stocks, 16.4% versus 15.3%.
The difference in returns across market segments is more significant when measured over the last twelve months. The market produced a return of 30.0%, but small cap stocks generated a return of 57.6% over the same period. Small cap value stocks have returned 66.7% over the last twelve months, while large cap growth stocks returned 28.9%.The differential favoring small cap stocks and small cap value stocks represents a reversal of trend that has been in place for almost twenty years, a period during which the return for large cap stocks exceeded that of small cap stocks on an annualized basis, and large cap growth stocks returned more than small cap value stocks. The reversal in the return differential is coincident with developing threats to a further extension of the trend of rising stocks prices.
The upward progress of the market during the quarter was interrupted in September. The market declined 4.7% during September. Large cap growth stocks were down more than the overall market, they declined 5.8%. Large cap value stocks, and small cap value stocks did slightly better as they declined 3.3% and 1.5% respectively. These declines seemed to reflect growing risks to continued economic growth, benign inflation, and satisfactory increases in corporate profits.
Market Commentary & Outlook
Economic growth, as reflected in industrial production and job formation, began to slow by the end of the third quarter. The rate of increase in industrial production peaked during the current recovery in April and has fallen by two-thirds since then. At the same time, inflation increased, and interest rates began to drift upward, albeit from a very low base. Unemployment fell to 4.8% in September, but the labor force participation rate was well below the level reached in March of 2020. If the participation rate equaled the 2020 high, unemployment would be over 6.0%, all other things being equal. The number of jobs in the civilian sector of the economy has increased above the low produced because of policy responses to the COVID pandemic, but the total number of jobs is still about 3 million below the pre-pandemic level.
Corporate profits continued to rise on a year-over-year basis during the quarter, but the price earnings ratio of the S&P 500 Index remained at close to 40x, well above the long-term average. The VIX, a measure of market volatility, ended the quarter at around 19, a level well below the level of 70 attained in May of 2020.
Monetary policy has remained accommodative, as the Fed continues to buy $120 billion in bonds monthly. As a result of the Fed’s actions, the monetary base has risen from less than $1 trillion at the end of 2007 to approximately $6.4 trillion currently. The Treasury has continued to run large budget deficits, and total Federal debt outstanding reached $29 trillion at the end of the quarter up from $10 trillion at the end of the fourth quarter of 2008. An increase in the inflation rate to 5.3% on a year-over-year basis has its roots in these policies. It is likely the inflation rate would be much higher, if the velocity of the circulation of money had not declined, and the savings rate had not increased during the economic recovery.
The history of the rate of inflation in the United States shows long cycles of increases and decreases. In the 1950’s, inflation was low and relatively stable. Inflation began to rise in the late 1960’s and rose more rapidly after August 1971 when the Nixon Administration closed the gold window. At the time of Nixon’s actions, gold was selling at $35 per ounce. The rate of inflation, as measured by the CPI, peaked at over 14% in the first quarter of 1980 at the same time real growth was declining. The inflation rate experienced a rapid decline as Fed leadership changed and economic growth resumed during the Reagan Administration. Benign inflation has been prevalent for almost 30 years until recently.
In the near term, the formulation of economic policy should be constrained by the size of the total burden of Treasury debt and a very enlarged Fed balance sheet. Unfortunately, within the context of an economy experiencing signs of declining real growth and rising inflation, proposed changes in economic policies represent a threat to market valuations and economic growth. The Fed has announced it will end quantitative easing in the not-too-distant future, and the current Administration has announced plans to increase tax rates on personal income, capital gains, and corporate income. Rising tax rates and a reduction of the rate of growth of the money supply characterize economic policies that have brought distress to markets and economic prosperity in the past.
The Biden Administration is proposing an increase in the tax rate on corporate income from 21% to 28%, an increase in the tax rate on capital gains from 29% to over 48%, and an increase in the top tax rate on personal income from 37% to over 39%. These increases in tax rates are intended to produce an increase in tax revenues sufficient to cover the additional $3.5 trillion in spending proposed by the Administration. JFK once tried to explain to Congress the difference between increasing tax rates and tax revenues. The current Administration should revisit the lesson. Tax revenues are likely to fall well below expectations. Market participants will manage their capital gains realization to minimize the impact of the increase in the tax rate. The combination of a reduced rate of growth of the money supply and increased tax rates will likely slow economic growth and reduce income and income tax revenues. The amount of unrealized capital gains will fall as economic activity and corporate profits fall.
If market participants believe that tax rate increases will come to pass in 2022, they will likely alter their behavior to minimize the impact of the increases. On the margin, capital gains and income are more likely to be realized by the end of 2021 before the increases take place. This behavior will place downward pressure on valuations, all other things being equal. Assets that have unrealized capital gains are more likely to be sold than those that have no gains. In cases where there is flexibility to do so, income will be brought into 2021, producing a spike in corporate profits and personal income during the end of the year, but tax realizations will fall below expectations in 2022.
Fortunately, if history repeats itself, the most destabilizing aspects of proposed policy changes are not likely to materialize. President Roosevelt raised tax rates and suffered a resounding defeat in the off-year elections of 1938. The magnitude of the defeat was eclipsed in 1994 after President Clinton raised tax rates in 1993. The Democrats lost control of the House to Republicans for the first time in forty years, and lost control of the Senate. President Clinton then changed course and cut tax rates. President Obama suffered a similar fate. Off-year elections have produced changes in control of Congress and a dampening of enthusiasm for increases in tax rates in the past.
The Fed will be faced with the daunting task of reigning in inflation while not precipitating a decline in real economic growth. The Fed has not been very adept at accomplishing this mission in the past. If the Fed does not alter its current policy, it is almost certain inflation will increase. An increase in the rate of inflation is likely to lead to an increase in interest rates as market participants seek to preserve real returns. The stock market will face significant challenges in the near term. With a valuation of forty times trailing earnings, increased volatility in stocks prices should be expected while new economic policies unfold.
Sources: S&P Dow Jones Indices, US Bureau of Labor Statistics, CBOE, Bureau of Economic Analysis
The information and statistical data contained herein have been obtained from sources, which we believe to be reliable, but in no way are warranted by us to accuracy or completeness. This report includes candid statements and observations economic and market conditions; however, there is no guarantee that these statements, opinions, or forecasts will prove to be correct.