The quarter began strong with the continuation of the torrid market rally that began last spring. July posted a positive return for the S&P 500 of 2.4%. August followed with an even stronger 3.0% gain. September, however, saw the first decline for the index since January with a decline of –4.7%, which was the largest monthly decline since March of last year, when the COVID-19 crisis first roared through the market and economy.
The proximate cause of the recent market decline has been a slew of mounting uncertainties in the economy and stock market. Looming tax hikes, political clashes over the debt ceiling, mounting inflation, economic weakness, and top heavy stock valuations have combined to throw an autumn chill into investor confidence.
In recent weeks, the never ending partisan bickering in Washington reached a crescendo. The debate has centered around aggressive spending and tax proposals introduced by Democratic leaders. Predictably, these plans have been met with stiff opposition, not only from Republicans, but also moderate members of the President’s party. Despite a majority in the House and Senate, consensus on these proposals has eluded Democratic party leaders thus far. More urgently, the policy divide has spilled over to the ordinarily routine matter of raising the country’s debt ceiling which, if not resolved, threatens the prospect of the government being unable to meet its short-term financial obligations.
Since it was first passed into law in 1917, the debt ceiling has been raised by Congress more than 100 times. Most of the time this happens in a very routine manner. But every so often, when hot button legislation is on the line, the debt ceiling can become a powerful political bargaining chip. In extreme instances, the government has been forced to shut down and furlough “non-essential” employees until the issue has been resolved. This has occurred 10 times, most recently in 2018 while then President Trump was seeking funding for a border wall. Congress has very recently passed a short-term measure to fund the government for the next two months, but a longer-term solution has yet to be reached.
This time, the debt ceiling squabble is over the proposed combined spending bills, which has been debated in congress for several months. The bills are expected to cost as much as $4.5 Trillion over the next 10 years, and are meant to provide funding for roads and bridges, mass transit and rail, internet upgrades, improvements for airports and shipping ports, and power and water systems, as well as a host of new and expanded social problems. This new spending would be paid for by increasing taxes in a number of categories; primarily corporate taxes, income and capital gains taxes for wealthy families, and estate taxes. With so many moving pieces, there are plenty of opportunities for more partisan fighting.
As the economy emerges from the worst of the COVID-19 crisis, there have been many unexpected disruptions. Demand for computer equipment and factory shutdowns have combined to create a severe microchip shortage that has limited activity in a number of key industries. A notable example is that car manufacturers have had to slow (and in some cases halt) production of new vehicles. Additionally, workers reluctance to work has resulted in a smaller workforce, which in turn has left many businesses unable to fill open positions. A particularly concerning example has been a shortage of workers at important shipping hubs, which has greatly complicated and delayed worldwide shipping.
Additionally, the surge in the Delta variant of COVID-19 has cooled what was otherwise a strengthening rebound in the economy and has further compounded the above-mentioned disruptions in many corners of the economy. These disruptions have contributed to an uptick in inflation that has been more persistent than previously expected. In the most recent reading, the Consumer Price Index rose 5.3% on a year-over-year basis. This is a bit higher than the long-term average of 3.9% and much higher than the average of roughly 2% over the past decade. However, most economists expect the supply disruptions to resolve and inflation to normalize to a range of 2-3% in the coming months.
In addition to the items outlined above, investors have become increasingly concerned with rising valuations in the stock market. For the past 10 years, the S&P 500 has returned an astonishing average of 16.6% per year. This has taken the price-to-earnings ratio (P/E) of the S&P 500 based on expected forward earnings from about 11x to the current level of 20x. This is higher than the long-term average of 17x, but still well below the lofty valuations seen during the tech bubble, which topped out at roughly 25x.
The S&P 500 has declined -5% from recent all-time highs set at the beginning of September. Although this is an unwelcome departure from the very consistent upward market action of the past year, it’s important to remember that pullbacks are a very normal part of investing. As the chart below shows, most years have seen much larger pull backs. The average pullback in any given year is about 14%.
S&P 500 Intra‐Year Declines vs. Calendar Year Returns
For the remainder of the year, we expect the market to continue to rise, but the day-to-day activity to remain choppy. In 2022, we expect COVID-19 concerns to subside and the supply chain bottlenecks to normalize. This should lead to the long-awaited liftoff in the economy which should have a positive effect on corporate earnings, and by extension, the stock market. But as we’ve learned over the past two years, we should always be prepared for the unexpected.
Thank you very much for your continued confidence in our service and advice. If you would like to discuss our opinions, outlook, or your portfolio in greater detail, we would be happy to schedule a meeting or a conference call at your convenience. Lastly, don’t keep us a secret. If you know someone who would like help planning for their financial future, we will be pleased to speak with them to see if we can assist.
Horizon Wealth Advisors is a Houston based fee-only wealth management firm. Horizon is a fiduciary advisor. We specialize in helping successful individuals and families understand, organize, and manage their often complex financial situations. Horizon offers integrated financial planning and investment management services.
Owen Murray, CFA
Owen Murray joined Horizon Advisors in 2005. As a core member of the wealth management team, Owen is principally involved in investment research and portfolio construction.