While US equity markets made all-time highs during the quarter; a September pullback erased gains and left markets flat-to-down for the quarter. Bonds provided no reprieve, also selling off in the quarter as rates ticked up in response to inflationary pressures.

3^rd Quarter 2021 Capital Market Returns

Bloomberg Barclays Global Aggregate       -0.80%

S&P 500 Index                                                  0.50%

Russell 1000 Index                                         -0.26%

Russell 2000 Index                                         -5.14%

MSCI ACWI Index                                           -1.21%

MSCI Emerging Markets Index                    -7.55%

MSCI Frontier Markets Index                        3.03%

We have been commenting on the highly supportive monetary policy and fiscal stimulus in response to the COVID-19 pandemic. There is no doubt the policy response was instrumental in leading to the rapid recovery from the economic collapse caused by the pandemic-related closures. But at what cost?

The policy response has led to:

• record money supply
• record stock market levels
• record stock market valuations
• record home price levels
• record home price valuation levels
• record margin debt
• record budget deficit levels
• record national debt levels, and
• increasing inflationary pressures throughout the economy

To a certain degree this has the feeling of prosperity; people have money—and they are spending it and investing it. But at the same time, these conditions provide an eerie sense that something is not quite “right” or quite “real” about it; kind of like being in a virtual reality game for a few hours. The question is: What will life be like after we exit this state of suspended reality and re-enter a world of laisse faire capitalism (or at least something closer to it than we are now)?

For a long time, our response to living in the present conditions has been to say “don’t fight the Fed.” This is a way of saying so long as policies are accommodative, we are likely to stay in a market state similar to its current state. Afterall, stocks have been historically expensive for a long time.

At some stage, Fed will reverse their present policies and valuations will revert to the mean. When this happens, different paths are possible. At one extreme, this could occur gradually, with minimal volatility and a slow process of stock earnings growing into their valuation levels over several years. At the other extreme, we could get a rapid downward repricing of stocks with valuations normalizing much more rapidly. The likely path probably will contain elements of both extreme scenarios. We know from past experience that after such periods of lofty valuations, stock returns are tepid and below their long-term average returns for an extended period. Whenever the present episode ends, we expect this to play out again.

We feel confident the Fed is attempting to orchestrate the first scenario above: a gradual earn-in to valuation levels as stocks consolidate at present levels and earnings “catch up.”  This seems to be the intent of the Fed’s “taper” strategy to its current Balance Sheet buying program. The Fed is on record as saying the taper will begin in the fourth quarter of this year. The current buying level of $120 billion per month will be reduced by $15 billion per month until the monthly buying is reduced to zero about eight months after the taper program begins.

Will it work? We don’t know. But the stock market’s retreat in September seems to suggest an impending sense that it might not. Given all this uncertainty, what is the prudent course for most investors?

4 Ways to Take Action

• First, rebalance toward long-term asset allocation targets, to include:
  • Reducing top outperforming asset classes
  • Increasing underperforming asset classes
• Second, inside of asset classes, begin to take some defensive measures to include:
  • Trimming or selling high valuation securities
  • Adding more defensively oriented securities
  • Reducing bond duration
• Third, international equity markets are less expensive, so:
  • Increase international equity allocations but stick with developed markets
• Fourth, be prepared with a more defensive strategy should conditions deteriorate to include:
  • Raising cash
  • Introducing defensive equity strategies
  • Reducing both equity and bond allocations

We will watch breaking information carefully and recommend more defensive strategies and tactics as appropriate.

Erik Ogard, CFA