Date: October 19, 2021

***Q3 Client Update***

Many people like to read my very “brief” quarterly client update which I select excerpts. If you’re one of them, please read on. If not, feel free to stop now. Always happy to hear comments and questions.

I would rather have been wrong on my forecast and perfectly right on our models. How’s that for a sentence to begin my Q3 report? Over the past few months, I have concluded every single client meeting with my thoughts that gains in the stock market were too easy and that the rally would moderate and pullback, at least modestly. Coming into 2021 and for most of the year, I often wrote that I expected the stock market to peak by Labor Day and see its largest bout of weakness since October 2020. And if that scenario played out, I had hoped that our models would begin to play some defense.

As I stated to open this report, I would rather have been wrong on two counts. First, Q3 would have been easier had the markets not pulled back over the final four weeks of the quarter in the fashion they did. And second, not all of our models started to play defense as I hoped they would. Thankfully, as the quarter just ended, the decline in the S&P 500 has been limited to roughly 5% with the more “risk on” indices showing more decline and it does not look as though much more is coming on the downside so far.

Over the summer months, I continued to conduct most client meetings over Zoom, however, slowly, clients began to return to our office to meet. In the end, it does not matter to me how we meet as long as we do, in fact, meet for retirement projection updates, portfolio reviews and social security analysis’. When I meet with prospective clients, most ask how often we will meet; to which I answer that I am happy to meet as often as you like. New clients tend to accept my meeting invitations more frequently than those who have been with me for years and years. I always hope it is because longevity equals comfort and trust and not because I bore them, or they have a hard time looking at me for an hour.

Anyway, please continue to know that I am always interested in meeting, whether it is to create or update retirement projections on your financial situation, review the strategies in your portfolio, run social security analysis’ on when and how to file for the best benefit, discuss your estate or even smaller transactional-type issues like securing a mortgage or weighing insurance.

The third quarter saw so many different things and, finally, it was much more than just COVID. However, I will start with the pandemic which took a nasty turn with the Delta variant. Everyone knows how often I write and say that it’s not what the news actually is, but rather, how markets react. Over the first four plus months of 2021, economically sensitive sectors and stocks were all the rage. After all, the economy was continuing to reopen, growth was soaring and a major trillion-dollar, bipartisan infrastructure bill was going to be passed to fix the nation’s crumbling roads, bridge, tunnels and other traditional projects.

However, as inflation roared and became white hot, long-term interest rates fell instead of jumping higher as you would expect. In the stock market, materials, industrials, energy and financials peaked and then declined straight to the end of Q3. In hindsight, that was the market telling the world that the highly contagious Delta variant was going to stop the return to normalcy and slow growth, and the much-ballyhooed infrastructure package was going to get caught up in politics. We also learned that the three approved vaccines saw their efficacy wane as they aged and booster shots will likely be needed going forward. As the quarter ended though, COVID case counts, hospitalizations and deaths were all on the sharp decline.

The Olympics came and went in Q3 and it certainly seemed disappointing. While the U.S. did win an enormous number of medals, the team did not dominate in the high-profile sports like gymnastics and track and field. Additionally, corporate advertising and the associated buzz was definitely lacking. Where were the immediate Disney and cereal box ads with the big winners? Also in Q3, the Biden Administration completed the final withdrawal from Afghanistan, what has supposedly been the longest war in U.S. history and certainly the costliest. The old adage that war is good for the economy definitely did not apply to Afghanistan.

The initial public offering wave (IPO) continued in Q3 with very high-profile companies like Robinhood and Chinese rideshare, Didi, coming to market. The former has been surrounded in controversy over its revenue model and gamification of investing although plenty of institutions snapped up shares. The latter, however, has been a disaster as the Chinese government pivoted and began attacking their own companies and floating a trial balloon about those with listings in the U.S.

Getting back to the U.S. economy, you already know that I forecast strong GDP growth in 2021. While I did not see the consequences of the Delta variant, the economy still grew in Q2 and Q3 with the unemployment rate continuing to decline month after month after month. The big disappointment in Q3 was the lack of new jobs created. The monthly employment reports kept coming in significantly less than economists expected. While economists have a worse accuracy rate than meteorologists, it was a particularly difficult quarter to forecast.

Given the anecdotes I have shared regarding clients in the restaurant and landscaping businesses with the inability to hire new workers even with higher wages, I was confident that once the additional COVID unemployment expired on September 30, the outlook would change. 31 states had ended that extraordinary measure over the summer, but the data had not been released on whether my hypothesis was correct. We should see that shortly.

With the economy weakening over the summer but inflation remaining white hot, Jay Powell and the Federal Reserve’s Open Market Committee were in a quandary. They have been purchasing $120 billion a month in Treasury and mortgage-backed bonds as a crisis measure to support the economy and markets. While they agreed to let inflation run above their 2% goal for a longer period, it printed 5% and commodity prices skyrocketed.

You already know my position on the Fed. The crisis had long passed, the economy was humming, and they should have ceased their bond purchases long ago and certainly before Q2. It has been almost impossible to argue that the Fed should be buying mortgage-back bonds to help the red-hot housing industry. Finally, at the now virtual annual meeting in Jackson Hole, WY, Jay Powell floated his own trial balloon on the possibility of discussing an eventual plan to taper their asset purchases. In September the Fed machine paraded out no fewer than 5 members who strongly advocated for the taper to begin in late 2021. The financial markets were non-plussed, something to remember.

Speaking of the financial markets, the third quarter was a tale of two periods, July-August and then September. The first part saw another surge in corporate earnings that handily beat expectations, yet again. Some opine that was the peak in earnings growth. But remember, peak earnings growth typically occurs early in the new economic cycle where growth is the strongest and beating the prior year’s recession numbers are easy.

September saw the broad market decline with leaders like technology hit hard and the first 5% pullback since October 2020. This was wrongly blamed on the Chinese real estate developer bust, Evergrande, debt ceiling worries, supply chain problems and 1970s style inflation. The media always need to assign blame to something. The stock market was ripe for a pullback. That’s the important takeaway. And it should be limited to single digits. Until proven otherwise, bouts of weakness are to be bought.

Overall, the major stock market indices were mixed, but remained firmly solid for the year. Sector behavior saw the continuation of the major pivot back into technology and more defensive issues at the expense of the economically sensitive areas like financials, industrials, materials and energy. Growth led value. This was due to Delta’s impact on growth. However, September began to see an unwinding of the narrow, technology-led leadership and back into the reopening/reflation/inflation trade which is a long way from being over.

On the inflation front, a theme I started to mention in the summer of 2020, it continues to be interesting to note that the monthly white-hot reports on the consumer and producer levels do not cause intuitive reactions. By that, I mean that bonds rally, gold declines and economically sensitive stocks do not rally. The markets either seem very comfortable with inflation running at its highest levels since 1991, or they are forecasting a peak in the next 3-6 months. And just because inflation may peak doesn’t mean it is necessarily trending down. It may go sideways or a little lower.

The most important takeaway and perhaps the most misunderstood feature of inflation is that prices must continue to rise for inflation to remain high. For example, gas goes from $2 a gallon to $4 a gallon. In order for inflation to continue, gas prices must go even higher and higher. If gas stays high at $4 over the coming quarter or year, that shows there is no inflation because prices did not continue higher. Many people think that inflation equals high prices. That’s not correct.

At this point in the report, I usually write about my barbell strategy to investing. If you picture a barbell from the gym, there is a long, thin bar with big weights on both ends. Think of those weights as our conservative strategies and aggressive ones, the exact proportions do not matter yet. In theory, your money would have higher weights to conservative and aggressive strategies, especially if you are in or very close to retirement, and lower allocations to the middle of the road strategies.

This barbell approach has also worked very well with monies being transferred in from 401K and 403b plans as those pre-packaged plans rely heavily on bonds for the more conservative approach and do not account for interest rates rising. Additionally, their aggressive choices do not usually reward the risk taken. If you would like to learn more about the barbell approach, we can set up a meeting, call, Skype or Zoom.

The stock market did not achieve my next target of 36,000 in Q3, but that should be in the cards for late Q4. As I have said before, I did not envision the stock market having this strong of a year, but that forecast certainly did not preclude our strategies from taking advantage. The stock market should make a bottom in October and rally to new highs in Q4. The rally should be broad-based and see all five indices in sync to the upside with both ends of spectrum, NASDAQ 100 and small caps, garnering investor attention.

While the market has rewarded technology and the economically sensitive sectors on an alternating basis, Q4 should reward both. Tech is poised to bounce strongly, and materials, industrials, financials and energy should continue higher as the reopening/reflation/inflation trade presses on with Delta fading and GDP poised to beat growth expectations. In short, I am very positive on the markets and economy as Q4 begins.

As you know, I always try to test my forecast by asking myself how I will be wrong. If I am wrong, I do not believe it will be because of any of the known concerns. Something else will pop up and I have no idea what. However, we usually see the potential for market vulnerability in the data and indicators ahead of time. I will be keenly watching the behavior of high yield bonds, one of my favorite canaries in the coal mine, which have been weakening since mid-September. I also want to see more stocks participating than we have seen in months.

The Fed is going to announce their plan to taper or reduce their monthly purchases of treasury and mortgage bonds. That should happen in early November with the plan beginning in December. By summer 2022 it should be complete. After that, short-term interest rates will rise, after inflation peaks. It should not be that way. Rising inflation requires prices to continue to rise month over month and year over year. I do not see that lasting throughout 2022. The popular catch phrase, supply chains issues, should peak sometime by Q1 2022 and the economy will continue to normalize, for better or worse.

It has been so great to greet and meet clients in person again in the office although I think I speak for many when I say I have mask exhaustion. Zoom and Skype have become a way of life and I will always offer virtual meetings for those who prefer. I don’t care how we communicate or meet as long as we do. I am so thankful for such a trusting, loyal and supportive client base.

Please continue to share your feedback, positive and negative. Investing is a marathon not a sprint and the long-term future continues to look very, very bright. We look forward to sharing that with you over the coming years. Again, here is the link to my calendar to schedule a meeting in the office, call, Zoom meeting or Skype.

Thank you for the privilege of serving as your investment adviser!


Heritage Capital, LLC

Paul Schatz

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Paul Schatz, President, Heritage Capital