Quarterly Update

Market performance was solid during the second quarter (Q2) of 2021. US stocks completed their 5th quarter in a row of 5+% returns and even the bond market staged a bit of a comeback after lagging during the first quarter. The economy continued to rebound from the pandemic and Q2 ended with just about all states being fully open for business. Concern grew during the quarter, however, about high stock market valuations, a spike in inflation, and how long the recovery boom might last.

Here’s a roundup of how major markets performed during the second quarter and year-to-date, respectively:

• US Large Cap Stocks: up 8.4%, up 15.3%
• US Small Cap Stocks: up 4%, up 17.4%
• US Core Bonds: up 1.9%, down 1.8%
• Developed Foreign Markets: up 5.4%, up 9.6%
• Emerging Markets: up 3.8%, up 7.2%

The stock market performed well during Q2 without much drama. There was a brief pullback of about 4% for the S&P 500 in May, but otherwise stocks mostly moved higher. All sectors were positive except for Utilities which was down only half a percent. Top performing sectors were Technology and Communication Services, up 11.4% and 10.9%, respectively. Energy was also up 10.6% during Q2, mostly driven by rising oil prices. The sector was also the best performer year-to-date, up 45%. As has been the trend for some months, the worst-performing sectors of last year turned out to be the best during Q2 and year-to-date. Small company stocks, which performed horribly for much of early-2020, have outperformed so far this year. And the US continued to outperform foreign markets, but the latter picked up some slack and crossed an important technical threshold as Q2 ended, potentially indicating stronger performance to come.

As most of our economy reopened millions of consumers rushed to spend what’s reported to be an abundance of cash. This, coupled with vast pandemic-driven supply chain issues, created a surge of inflation during April and May. According to the Bureau of Labor Statistics, the Consumer Price Index hit an annualized 5% in May after an extended period of less than half that. With inflation concerns mounting, the Fed reassured investors that this was expected coming out of the pandemic and shouldn’t be a problem. The messaging didn’t appease investors and led to the modest downward move for stocks alluded to previously.

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Investors quickly settled down, however, and got back in line with the adage of “don’t fight the Fed”. The thinking is that supply chain issues will resolve, consumers will calm their spending and, overall, the economy will get back to more normal levels of inflation in a year or two. In other words, if the Fed isn’t worrying, why should we?

Part of what is expected to moderate inflation, at least in terms of what the Fed is tracking, are the millions of people still out of work. Q2 ended with an unemployment rate of 5.9% and low claims for new benefits, but also historically high levels of the so-called continuing unemployed. Currently there are nearly 15 million people enrolled in all federal and state unemployment programs across the country, up from a Great Recession record of about 6.6 million, according to Bespoke Investment Group. This is interesting considering the high numbers of job openings across the economy. These openings are primarily in entry-level service jobs and many small business owners are having to get creative to lure new hires. Many of these workers may be driven back into the labor market as more states stop participating in pandemic-related unemployment programs. The Fed has said inflation won’t truly be a problem for the economy until most of these folks are back to work, so this should be watched closely in the coming months.

While continued positive returns can’t help but make us happy, a mixed outlook continued to evolve during Q2. Individual investors quickly grew more bullish, even amid inflation concerns. This kind of sentiment change by the so-called dumb money is traditionally viewed by many in the smart money crowd as a contrarian indicator. Bullishness is extreme in some corners of the market, but not yet for stocks more broadly.

There’s also concern about waning momentum given how far we’ve come so quickly out of the depths of the pandemic. Housing prices are a good example of this. Prices shot up dramatically last year and have remained elevated on extremely low inventory and a reshuffling of buyer preferences. The Mortgage Bankers Association reports that applications for new mortgages peaked recently and continued to fall into quarter’s end. This, along with worsening sentiment readings from a variety of consumer surveys show that buyers are discouraged by high prices. This isn’t expected to crash the housing market, but it’s reasonable to assume that price growth should slow. This would impact the overall economy as consumers begin to feel constrained by a decline of the so-called wealth effect.

Ultimately, the caffeine high the economy and markets are on will wear off. Stock investors are constantly looking for growth and there will come a time, perhaps not soon but eventually, when publicly traded companies won’t be able to show as much of it. Short-term investors will likely react negatively to this but long-term investors like us will plan to take it in stride as a normal outcome following a decidedly abnormal and tragic period in our nation’s history.

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