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The ValueAligned Model Portfolio (“VAP”) is up +15.8% for 2021 as of Wednesday, September 8th. The S&P 500 Index is up +21.4%. Please see the disclosures at the end of this letter or on our website www.valuealigned.com.
 
We lowered our exposure to stocks in August after a few growth stocks went into the red. We harvested those losses and raised some cash.

The ‘seemingly’ unstoppable bull market

Whether from clients or acquaintances, there has been no shortage of inquiries about the market’s astounding rise.
During August, we saw multiple highs on the broad-based S&P 500 Index, while the tech-heavy NASDAQ Composite topped 15,000 for the first time, according to data provided by Yahoo Finance.

Let’s offer a simple perspective. On August 18, 2020, the S&P 500 Index closed at a new high of 3,389.78, erasing all the losses incurred during the lockdowns and the Covid recession, according to S&P data from the St. Louis Federal Reserve. The S&P 500’s prior peak of 3,386.15 occurred on February 19, 2020.

Since eclipsing its former high, the S&P 500 Index has racked up a gain of +33.4%, excluding reinvested dividends, through August 31, 2021. Put another way, this is an advance of over +30% in just over one year.
Sure, it’s a back-of-the-envelope analysis, but it illustrates one simple idea: the rise in the stock market has been impressive.

That said, let’s get back to the question about the market’s astounding rise. Most folks don’t understand it. I’ve heard it in casual conversations, and you have probably heard it, too. And many seem to expect (or want) a significant pullback.

We get it. While we are a strong believer that a diversified approach to stocks helps one participate in the long-term permanent uptrend, we are hesitant to try to time the market or predict where a major index might be in one month, six months, or one year. However, we’d never discount the possibility of a market pullback over the near term.

Yet, the sharp run-up suggests that stocks are priced for perfection. When stocks are priced for perfection, we would subscribe to the idea that the market could be vulnerable to a selloff, since any negative surprises can broadside overly optimistic investors.

We have seen it happen before, but it has not happened over the last year. Declines have been minor and short-lived.

Absorbing unexpected surprises

During August, the rise in Covid cases tied to the Delta variant caused brief volatility, but investors are not on board with the idea that the health crisis will substantially slow the economic recovery and dampen corporate profits.

While some locales are re-implementing mask requirement, we have yet to see the type of restrictions that were in place in 2020 and early 2021. For now, the market is viewing the vaccines as an inoculation against a rapid slowdown in the economy.

We also saw tragic events play out in Afghanistan. While the images have been difficult to see and the geopolitical ramifications are unknown, simply put, investors don’t expect the U.S. withdrawal to have an impact on U.S. economic growth over the next six to nine months.

I recognize that’s a harsh way of viewing an unsettling situation that is tragic for many. But investors, both large and small (who continually and collectively make buy and sell decisions) have a very narrow lens. That lens is primarily targeted toward future economic growth, profits, Federal Reserve policy and interest rates.

Let’s look at it from a more practical angle. Will consumers decide to delay a vacation, a big purchase, or simply decide to eat at home rather than dining in a restaurant because of what’s happening in Asia? It’s highly unlikely.

Are stocks priced for perfection? In hindsight, all the ingredients for a strong rally have been in place over much of 2021:

  1. a strong economic recovery,
  2. much better-than-expected corporate profits,
  3. plenty of cash, and
  4. extremely low interest rates.

Let’s review one of the pillars that has been a significant support for shares: low interest rates.

Low interest rates not only help fuel stock market gains, but low rates also help support higher valuations.
While we will spare you the mind-numbing financial minutia valuation, a quick way to explain how low rates influence stock prices is with a simple example.

Low interest rates between 0% and 2% on US Treasury bonds and bank deposits provide very little competition to the earnings level and growth of stocks of great companies.

Low rates encourage investors to look at stocks and other riskier investments rather than settle for safe but paltry returns – most are negative after inflation and taxes.

That’s right you are losing money if you hold lots of cash and other fixed income investments, especially now that so many prices are rising so fast.

This is especially true when the economy is expanding, corporate profits are soaring, and Wall Street stock analysts are ramping up future earnings estimates. It is not simply low rates, but low rates combined with strong profit growth.

The earnings-led melt up in stock prices continues.
Usually, the fourth quarter of each year tends to be the best one for earnings. This year second quarter (2Q) earnings blew past analysts’ consensus expectations for the for the stock market.

Sales growth has been boosted by lots of Federal Reserve Bank (FED) and congressional money. But the big story is that profit margins (profit/sales) continue to expand into record high territory. Why?

The pandemic accelerated the pace at which businesses are incorporating productivity-enhancing technological innovations to deal with the challenges resulting from the pandemic, including severe labor shortages. We just heard that there are now a record number of Jobs open, about 11 million. They say that the opera ain’t over until the fat lady sings.

The opera ain’t over for the bull market in stocks, but it’s hard to imagine that the year over year growth rates in S&P 500 revenues per share and operating earnings per share will beat Q2’s 18.5% and 87.7% anytime soon. Both sales and earnings rose to new record highs during Q2. And look at the S&P 500’s profit margin, which set yet another record high of 14.0% during Q2.

Is Jerome Powell a Fat Lady?

Looking ahead, Fed Chief Jerome Powell said that the Fed is openly pondering a cutback in its monthly purchases of bonds; however, he did not provide a firm timetable.

Many analysts expect something more concrete will be forthcoming this year. But the Fed hasn’t committed, which gives it wiggle room in the event economic growth or job growth unexpectedly slows. But any reduction in bond buys will be well telegraphed.

Furthermore, Powell insisted last month that rate hikes are not on the table right now, and the hurdle to raise interest rates is higher than cutting back on its monthly bond buys.

As we have said before, the pace of economic growth, employment growth, and what happens to inflation will likely have the biggest influence on when and how quickly interest rates might rise.

As we enter September, investors will consider whether lofty valuations can hold up to the unwinding of fiscal stimulus and the potential for a reduction in Federal Reserve bond buys later in the year. Eventually, a market pullback is inevitable. For now, powerful tailwinds have been supportive.

Thank you for being my clients. It is a privilege to serve you.

I’m at david@valuealigned.com or 732-800-2375. Feel free to call me direct on my cell phone at 732-284-1267 (or text me too).

Best regards, 

David