While the economy is still expanding, the pace of the expansion growth slowed a bit in the third quarter. Many in the U.S. were expecting that summer would see a return to a somewhat more normal way of life – whatever that even means anymore. However, the more severe Delta variant disrupted that base case scenario, as consumers mostly pulled back and those looking for employment stayed on the sidelines. The days of forced economic shutdowns may be a thing of the past, but just enough activities were willingly curtailed due to fear and unease.
Covid cases appear to have peaked in the U.S. during the middle of September, and the expectation is for continued recovery and economic expansion – although there is uncertainty heading into the 4th quarter due to Covid-related supply chain issues. Nearly 60% of the U.S. population is fully vaccinated and a substantial number of individuals may have natural immunity after contracting the virus. The Pfizer vaccine should be approved within weeks for those between ages 5 and 11 – adding further protection and more clarity within schools. Booster shots are available now in the U.S. to further protect the more vulnerable that were vaccinated many months ago.
Nearly all Covid model forecasts predict virus cases declining through November and into December. Hospitalizations and deaths – the real metrics to monitor – should also improve. It does seem like we are in the later stage of the pandemic – and it likely will become endemic with the virus continuing to evolve and exist. Relatively high immunity in wealthier countries and eventually elsewhere will hopefully keep the most severe future scenarios at bay, though areas with lower immunity levels may suffer from additional waves.
Most equity indices were sideways or down in the third quarter. The S&P 500 Index eked out a gain of 0.6% – the sixth straight quarterly gain for the index. Smaller companies in the U.S, defined by the Russell 2000 Index, declined 4.4%. International markets were down as well, with the MSCI EAFE Developed Market Index down 0.4% and the MSCI Emerging Market Index down 8.1%. Bonds were flat as well, with the widely followed U.S. Aggregate Bond Index up 0.1% for the quarter. While it is comforting for investors to constantly experience a stock market setting all-time highs, the consolidation of the last 3 months has allowed for valuations to become even more reasonable.
Earnings and Inflation to be in Focus in Coming Weeks
The bar for Corporate America has continually been raised over the last year. Almost 90% of companies outperformed earnings expectations in the 2nd quarter – and many beat projections by a wide margin. It is now anticipated that earnings will rise by nearly 43% this year with revenue growth of 15%. This almost unheard-of earnings momentum is partially due to extremely low base comparisons from the second quarter of 2020 and due to rising consumer demand this year.
Typically, analysts reduce earnings estimates during the quarter. Over the last 10 years, the average decline in earnings estimates during the quarter has been 3.7%. However, the third quarter was the fifth straight quarter where analysts actually increased earnings expectations throughout the quarter – and that increase was 2.9%.
Why are the analysts increasing the earnings estimates as the quarter transpires? Because companies are delivering more positive forward guidance than usual. At the end of the third quarter, 103 S&P 500 companies issued guidance for the quarter, with 56 issuing positive guidance and 47 issuing negative guidance. This forward guidance is more positive compared to the last 5 years, where the average positive guidance was only 39 and the average negative guidance was 61. Specifically, most of the positive guidance was attributed to top-line revenue. Demand is increasing for goods and services throughout the economy as the U.S. and much of the world continues to reopen.
The concern lies with profit margins that may be pressured from rising costs associated with supply chain disruptions and wage increases. Indeed, later quarterly announcements in August and September highlighted the growing problems with supply disruptions from shut-downs elsewhere in the world combined with pandemic-related shipping shortages that have curtailed the ability of companies to meet demand.
Inflation seems to be broadening out and could linger for longer than many believed earlier this year. The Consumer Price Index (CPI) and the Federal Reserve’s preferred “Core” CPI metrics jumped significantly in May and remain elevated. The CPI has reported 5 consecutive months above 5%. Alternative inflation measures that strip away idiosyncratic swings in supply and demand (such as airfare and rental cars this summer and other extreme price swings) show that inflation may not be as extreme as the headlines show, but that it is picking up.
Some would interpret this as inflation returning to levels consistent with a growing and healthy economy. After all, inflation has been subdued for four decades and deflation has been the bigger concern in recent years. This may be why longer-term inflation expectations are still low for consumers and businesses.
Global Asset Allocation Strategy
Investment portfolios continue to carry greater exposure to equities as the economy reopens. There were no changes made during the quarter. Equities were last trimmed in May and primarily within smaller and mid-sized companies, which ran hard from November 2020 and became excessively overweight but have traded mostly sideways ever since.
The strategy remains diversified amongst sectors and company size. Valuation is preferable amongst smaller and cyclical names given that investors have recently bid up growth names centered in technology. Cyclical and smaller companies performed well when interest rates rose earlier this year and we expect that any further rate increases could positively impact these asset classes.
Foreign exposure is mostly developed and fortunately, there was little impact across portfolios from China’s Evergrande property market weakness. Recent U.S. dollar strength has created a temporary headwind for foreign assets but valuation is quite reasonable.
Bonds remain underweight, as yields are at historic lows. The intention of holding bonds has shifted almost entirely to liquidity, reduced volatility, and capital preservation rather than performance. Any material rise in rates – potentially due to either inflation fears or economic growth – could wipe out any ability to generate positive returns. Bonds remain mostly high quality and short-term in anticipation of rising rates.
Focused Equity Strategy
As mentioned, the S&P 500 posted a slight increase in the quarter, leading to a 15.9% return for the first three quarters of the year. Growth indices performed slightly better than value during the quarter, though still trail modestly for the year. Small-cap and international emerging markets were a drag in the quarter, which put emerging markets in the red (-1.3%) for the year. The overall returns of the indices belie a narrowing of the market and greater volatility in the underlying names.
A similar dynamic has played out in the Focused Equity portfolio, as we lean towards value, with a modest allocation to emerging markets. We did some trading in the quarter, reducing our allocation to energy as it rallied, then investing cash into companies that sold off. We still maintain an overweight in financials, relative to the S&P 500, on the belief that financial companies will benefit from rising interest rates, though we are not adding there. We shifted a little into technology, health care, industrials, and basic materials while reducing overall allocations to cash as we move to a policy of full investment.
We’ve detailed all but the most recent changes in separate newsletters to Focused Equity clients. Those include modest additions to Barrick Gold, Pfizer, AT&T, AMD, and Alibaba, along with sales of Halliburton and Helmerich & Payne. Most recently, we sold Pioneer Resources and added to Federal Express.
Pioneer Resources is an energy company that specializes in Permian Basin in West Texas. Most accounts picked up the stock when a prior investment in Parsley Energy was acquired by Pioneer last year. The company is extremely well managed with a strong balance sheet, but we believe it is priced at a premium to other energy companies. This sale reduces our allocation to energy to a slight overweight relative to the S&P 500.
Federal Express is a company we already owned, having sold half of our position on March 1st. While the valuation at that time was not necessarily stretched, we felt that it was a good time to take some profits. We were presented an opportunity a few weeks ago to add some back in at a lower price. Federal Express reported that it was having difficulty meeting surging demand for its services, and therefore was rerouting its trucks around bottlenecks and contracting more with third-party truckers. This will result in higher costs in the short-term, weighing on profits in the next few quarters. However, the strength of the underlying demand for their services as they gain market share, along with an industry tailwind from the shift to e-commerce, gives us greater confidence in their future prospects.
We like buying high-quality companies with strong growth prospects that are trading at a discount to our estimate of their intrinsic value. We found more of those opportunities in the recent quarter than normal, given the underlying volatility of the markets. We sell a stock when it has reached or exceeded our estimate of intrinsic value, or when the business prospects have changed or are otherwise different than we envisioned. Sometimes adjustments are made to the portfolio to manage the risk of the unknown, but we tend to hold stocks with three to five-year time horizons.
Stocks Still Preferred Over Bonds
Equity valuation is not cheap, but reasonable as long as earnings continue to be supportive and interest rates remain low. US large cap valuation is the most fully valued, driven by a narrow group of stocks, but valuation has come down considerably throughout the year. The more broadly-based small and mid-sized domestic companies are more attractive and positioned for the greatest long-term growth.
Regardless of equity asset class, we continue to prefer stocks over bonds given that bonds are yielding next to nothing. Investors with an over-reliance on bonds must be willing to accept lower long-term returns and the possibility of not keeping up with inflation. At the same time, investors that favor equities must be able to deal with the eventual bouts of volatility. There is not a “zero risk” option available for investors. Timeframe, risk tolerance and the required return necessary to accomplish financial goals will help to dictate which route investors should take.
As always, we are available to answer any questions!
 Factset “Earnings Insight”; October 1, 2021
 “Broader Inflation Pressures Begin to Show”; Gwynn Guilford; WSJ; Oct 4, 2021