Market Update

The S&P 500 rose 1.6% last week, setting a record in the process. The index peaked Friday at 4559.67 before finishing the week at 4544.90. Friday was also the lone down day last week and then only marginally. We wrote last week that the climb above the 50-day moving average opened the way for further upside. Upside is exactly what we got. The six-week pause in the stock market's advance may have been the pause that refreshed. Earnings season has been solid so far. Stock prices are reacting well to earnings news, something they didn’t do last quarter. Through Wednesday, 99 S&P 500 companies had reported. Ten have missed profit expectations, according to Barron’s. Shares gained an average of 1.6% on the trading day following a beat.

There are negative developments that could eventually cap the rally though. Interest rates continue to rise. The 10-year Treasury yield rose to 1.704%, the highest since April. The 5-year breakeven inflation rate has risen to 2.91%. It is the highest since March of 2005. The 10-year breakeven inflation rate has climbed to 2.64%, the highest since April 2006. Inflation expectations are important as they contribute to inflation. People's expectations are self-fulfilling to a certain extent. Federal funds futures are pricing in a more than 70% chance of a rate hike by June 2022. Federal Reserve members are indicating late 2022 as the most likely time for a hike. There is a disconnect that needs resolved.

Consumer confidence is also falling. The stock market and consumer confidence are usually highly correlated. The correlation has dropped recently. The S&P 500 is hitting new highs while consumer confidence numbers are falling. Consumer confidence did rebound slightly in September, but that was after dropping to its worst level since 2021 in August. The Conference Board’s Consumer Confidence Index also tumbled. The data shows that drops of at least 10 points in consumer confidence are predictive of recessions up to 18 months in advance. The Michigan index peaked in June and fell by 18 points by August. The Conference Board measure peaked in March and has fallen 26 points through September.

Norwood Economics expects a 10% to 15% pullback in the S&P 500 in the next six months. It is unlikely to occur in 2021 at this point. Seasonal strength should support the market into year-end. The market may flinch if the Federal Reserve does announce a reduction in bond buying in November. A small pullback is the most likely result though given the time of year. We are not expecting a recession until at least late 2023. It could happen sooner if the Fed is more aggressive than expected, which is unlikely. When the Fed surprises, it is usually a dovish surprise.

Economic Update

Industrial production fell 1.3% in September, the biggest drop since the pandemic began. Building permits were 1.59 million in September down from 1.72 million in August. Housing starts were 1.56 million down from 1.58 million in August. The decline in housing starts was blamed on supply chain problems. The Philadelphia Fed manufacturing index was 23.8 in October down from 30.7 in September. The October number is still considered healthy by economists, according to MarketWatch. The leading economic indicators rose 0.2% in September after rising 0.8% in August. The LEI in September points toward slower growth in the coming months.

Rising Investment Risk Revisited:

Last week we wrote about rising investment risk. We suggested investors should review their portfolios to make sure allocations were appropriate. Knowing what you own is important. Understanding the risks you are taking is also important. Every investor should always be evaluating portfolio risk. Tightening cycles usually don't end well. Understanding what to expect helps investors avoid mistakes, such as selling at the lows. Importantly, we are not suggesting you sell in advance. Market timing does not work. We are encouraging you to understand the risk in your portfolio so you know what to expect during a bear market.

Selling after large portfolio losses is one of the most common mistakes people make. It happens during every cycle. People are making money and embracing risk during the upcycle. They become increasingly aggressive with their allocations as the years go by and the stock market keeps rising. At some point the bottom falls out and they are down 30% or 40% before they realize it. And then they sell.

It happened during the 2000-2002 bear market. It happened again during the 2007-2009 bear market. People sold. Some never put money back into the stock market. Others waited until the new bull market was up 50%, 100%, or more before re-entering. The loss of wealth is enormous. I’m reminded of the 60-year-old I talked with a few months ago. She hopes to retire at 67. Her 401(k) account is 90% S&P 500 and 10% real estate. She will lose 30% or more in the next bear market. The next bear market will come before her hoped-for retirement date. She may even lock in those losses by selling after a large decline.

Norwood Economics makes sure its clients are appropriately invested. It ties the investment portfolio to the retirement plan. We do not allow our clients to become more aggressive as a bull market ages. Monitoring investment risk is one of our most important jobs as a wealth manager. Holding our clients’ hands through bear markets is another. Norwood Economics does not expect a bear market anytime soon, but we are always monitoring risk.

Regards,

Christopher R Norwood, CFA

Chief Market Strategist