Third Quarter 2021 In Review

Third Quarter

2021 In Review



We have said this before, and we’ll say it again… “Bull markets climb a wall of worry.” There are plenty of things to be concerned about, but how many of them really have a direct negative impact on the stock market?

– Polaris Wealth Advisory Group Tweet
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Third quarter of 2021 was anything if not turbulent. We experienced our first five percent correction in eleven months, as investors worried about inflation, tapering, a potential tax increase, and the threat of a government shutdown.

While the S&P 500 eked out a 0.23% positive return (as seen in the chart below), the quarter was filled with landmines as companies that had once been providing excellent returns reverted from their highs of the year. While we will provide you our normal updates on what is going on in our markets, we will also dispel why we believe the concerns listed above should not be concerns for you as an investor with Polaris Wealth.

By almost any account, investors have been rewarded with investing in the market this year. While performance has waned in recent months, the S&P 500 is still up 14.68% for the first nine months of the year (as seen in the chart below).

As you can see in the graph provided, value (black line) and growth (purple line), companies continued their tug of war during the third quarter, with growth outperforming value during the first two months of the quarter but falling significantly more than value during September as seen in the graph provided.

While large-cap growth and large-cap blend provided positive performance for the quarter, the markets were not kind to investors in other segments of the market. 


Yeat-to-date Performance

Small-cap investments suffered the most, with small-cap growth losing 5.75% for the quarter.

Large-cap growth now has the top year-to-date performance of any of the nine segments of the market.

We experienced a shuffling of sector leadership in the third quarter. Sectors of the market that had been leading the S&P 500 to new highs during the first half of the year, retreated during the third quarter. The top performing sector was the financial sector, up 2.7% for the quarter. Other notable sectors were utilities, communication services and health care.
Third Quarter 2021 S&P 500 Sector Performance
While the performance data doesn’t look too bad, there were some major landmines that impacted investors. Almost every sector had large, stalwart companies dramatically sell off from their highs earlier in the quarter. Companies like Amazon (-11.95%), Nike (-16.45%), Target (-13.37%), Nordstrom’s (-29.24%), Facebook (-11.20%), T-Mobile (-14.49%), Kroger’s (-14.54%), Clorox (-11.79%), Johnson & Johnson (-10.01%), Pfizer (-14.70%), Amgen (-14.50%), FedEx (-26.82%), and Qualcomm (-14.57%) had dramatic drops during the quarter. I could list another 20+ household recognizable companies that also sold off. This is but a small list of companies that had the rug pulled out from underneath them during the quarter. Investors were quick to judge companies that didn’t just beat their earnings but also provide positive guidance for their future.
Results were very mixed globally too. There were many countries that had strong quarters, like Austria, India, Argentina, Russia, and Japan. At the same time, you saw Brazil, Hong Kong, China, South Korea, Taiwan, and Peru drop dramatically.
MSCI All Country World Index Quarterly Performance Map
As a whole, second quarter earnings (reported during third quarter) were very strong. 87% of S&P 500 companies beat their estimated earnings per share. This is the highest percentage since FactSet began tracking this metric in 2008. We also saw record breaking net profit margins (13.1%) and revenue growth (25.3%). As you can see from the valuation chart, the forward P/E ratio on the S&P 500 dropped to 20.3. We expect the forward P/E ratio to continue to drop (more on this later).
S&P 500 Index: Forward P/E Ratio
We saw record breaking GDP growth. One thing that I’ve heard some investors express concern was that we were going to experience a slow down in our economy. Without question we will. We are experiencing the strongest GDP growth in 65 years. We would expect it to normalize, which would mean that we would expect our GDP to slow down significantly. That’s nothing to be concerned about. Our current GDP growth is due to government stimulus.
GDP Growth
Amazingly, this rebound has been so strong that the U.S. economy has recovered 100% of what was lost in 2020’s economic shut down.
.S. GDP • 1948 – 2021 (Constant Price)
We are far from being out of the woods. There are huge supply chain issues, unemployment continues to be an issue… Even though the chart provided shows that unemployment has dropped down to 5.2%, well below our historical 50-year average of 6.3%.
Civilian Unemployment Rate
There are two issues rising from our unemployment. The first is not particularly obvious. Right now, we have more job vacancies than we’ve ever had since the Bureau of Labor Statistics has tracked this figure. In fact, it’s almost 50% greater than the job vacancy rates pre-COVID.
U.S. Job Vacancies
The participation rate of Americans has dropped from approximately 61% to a little over 58%.
U.S. Worker Participation Rate
This three percent difference accounts for the difference between where unemployment was prior to COVID and where we are today. This combination has put employers in a position where they have had to “pay up” to get people to work for their firms. This has led to a 4.9% wage growth. Some are predicting that wage growth will remain above its 50-year average of 4% for some time. A stubborn wage growth and supply chain disruptions has many economists concerned that we will see an above average inflation rate for some time to come. As it is, we are experiencing inflation levels only seen a few times since the 1970s.
CPI Rates
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Current Observations

There are a lot of reasons to be bullish about the market for the rest of this year and throughout 2022. The estimated earnings growth for third quarter is 27.6%. If correct, this will be three straight quarters with 20%+ earnings growth. 

As seen in the chart provided, earnings estimates for 2022 and 2023 are predicted to be even stronger than the earning in 2021.

S&P 500 Projected Earnings Per Share
We do not expect the Federal Reserve to begin raising rates for some time. Right now, the Federal Reserve is buying $120 billion in mortgages and treasuries. The Fed is buying bonds in order to drive prices up and yields down. As you can see in the graph provided, the Fed has amassed over $8 trillion in bonds.
Federal Reserve’s Balance Sheet
We do expect the Fed to begin “tapering” these purchases, most likely in the next few months. It will most likely take the Fed several months to stop their bond purchasing program all together. We expect rates to go up as a result. Lower demand for bonds should force prices down and rates up as a result.
U.S. Bureau of Labor Statistics, FactSet, Federal Reserve, JP Morgan

As you can see from the charts provided, Fed Futures indicate that there is no chance that the Federal Reserve will raise rates in 2021. It is very unlikely that the Fed will raise rates by mid-year. Probabilities of a rate hike do start increase during the second half of 2022. The furthest Fed Futures indicate that the highest probability

is that the Fed will raise rates once by 25 basis points between now and February 2023. The next highest probability is that the Fed will not raise rates at all.

December 15, 2021 Fed Returns
une 15, 2022 Fed Fund Rate Probability
February 1, 2023 Fed Fund Rate Probability

Even if the Fed were to raise rates by 50 basis points, we do not believe such a move would have any impact on the long-term growth expectations.

While we believe inflation will remain higher for a longer period of time than we first projected, we do think that it is a temporary concern point. Don’t believe us? Look at how the market is reacting.

A lot of investors look to gold as an inflationary hedge. Why is gold down for the year if inflation was really something that institutional investors were hedging against?

Gold Prices
Dollar Index Prices
If inflation was truly occurring in our country, why has the U.S. dollar grown in value? Source: Tradingeconomics.com Dollar Index Prices
It is very important to understand how to navigate the markets when rates rise. As you can see from the chart provided, when inflation rates go up, value outperforms growth. There is a simple explanation. An investor buys a growth company based upon expectations of that company’s future earnings. Inflation can impact a company’s profit margin and earnings growth rate. A lower earnings growth rate means these growth investments are no longer worth as much.
Value vs. Growth Performance
An evaluation of “pure growth” and “pure value” companies illustrates the risk involved with investing heavily into growth companies. Value companies are trading at historic norms. Growth companies, on the other hand, are trading at 168% of normal.
Pure Growth vs. Pure Value Forward Price-to-Earnings Ratios

Another concern point that some of our investors have raised, and certainly something that was weighing on the markets their last few weeks of the quarter was the potential government shut down. We are going to steer clear of the politics behind this stalemate and concentrate on the impacts on the market.

There have been ten government shutdowns over the last 45 years. As you can see from the chart provided, half of those were during Carter’s administration. The markets are benign during government shutdowns, with the last four shutdowns providing investors with a positive return while the government was shut down.

The S&P 500’s Performance During Government Shutdowns
While no one enjoys paying more taxes, historically a rate increase has had little to no negative impact on the market. From 1950 to present, there have been 13 tax increases. Only once, in 1969, did the markets drop after a tax increase.
Tax Increases Through the Years

Conclusion

We have said this before, and we’ll say it again…“Bull markets climb a wall of worry.”There are plenty of things to be concerned about, but how many of them really have a direct negative impact on the stock market?

We have shown you that most government shutdowns have little to no impact on the markets. The drops that occurred during the Carter and Ford administrations were more to do with the current economic environment than the actual shutdown. We saw the markets rally during the last four government shutdowns. So why fear it?

There is the threat of taxes being raised to pay for all of the stimulus programs that have already occurred, and the new ones being proposed. While none of us like to pay taxes, these types of increases have historically not had a negative impact on the markets. There have been thirteen tax hikes over the past seventy years. Only once have we seen the markets tumble as a result.

Will inflation have an impact on your portfolio? Inflation has remained stickier than we originally thought, but there is no evidence that would indicate that we are heading into an elongated period of time (like the late 1970s and early 1980s) of hyperinflation. There are several things creating this temporary lift in inflation. The best way to combat inflation is to grow your portfolio. Getting too conservative with your portfolio will simply lower your real return (your portfolio’s return minus inflation).

We remain very bullish going into the fourth quarter and we look forward to that momentum carrying us into 2022. And we are not alone. Goldman Sachs has predicted a 9% rally during the fourth quarter. An aggregate of Wall Street analysts has predicted the markets will increase in value by 15% over the next 12 months. This does not mean that things will be easy. Investors are on edge. Sentiment swings almost on a daily basis and there will continue to be a tug-of-war between value and growth until a clear winner emerges. We are very confident that we will successfully navigate these turbulent times as we have done in the past.