The stock market experienced its first pullback in what has felt like a straight march higher since the spring of 2020. Markets initially rallied early but gave up most of its gains this quarter because of a September sell off. Worries that economic growth would miss its growth targets and shift to a mid-cycle economic recovery weighed on stocks. Growth rates are still excellent for the US and global economy, but expectations are being reduced because of the impact of the delta variant of COVID 19 as well as supply chain issues that are disrupting everything from auto manufacturing to holiday gifts arriving.

The S&P 500 experienced its first 5% pull in over 227 days. This is the 7th longest streak for this index between 5% pullbacks. In the quarter, larger companies outperformed small cap companies. This is understandable since smaller companies tend to be more sensitive to economic growth. Since growth expectations are being dialed back, small caps have given up more ground. Growth stocks managed to do better than value for the quarter as a whole.

The financial and technology sectors were the best performers in the quarter. Financials gained 2.29% and were lifted by the increase in interest rates seen during September. Banks and other financials benefit when rates are higher because it allows them to earn better returns from what they loan out and what they pay in interest. Tech rallied early in the quarter but sold off in September. The increase in rates that helped financials hurt technology shares. As interest rates rose in September, tech companies saw their price to earnings multiples shrink which squeezed their stock prices. Tech shares were up as much as 8% before giving up 6% in September. The only sector with a positive performance in September were in the energy sector. Energy rallied 9.3% in September on the back of a rally in natural gas prices. The last and only time the S&P 500 Energy sector was the only sector up in a month was June 2008.

Investment Strategy

Our investment strategy remains unchanged since last quarter. We continue to be overweight in stocks and underweight in bonds and cash. We believe this strategy is still prudent because stocks have a higher expected return while bonds may struggle if interest rates increase. As interest rates increase, bond prices decline. Our stock allocation is broadly diversified with no significant overweight towards any particular style or market cap. Our holding in low volatility stocks should offer some positive performance as the market shifts from an early growth cycle to a mid-cycle growth.

Outlook

A shift is taking place in both the markets and the economy. The rapid growth of the early economic recovery is transitioning to more moderate growth seen in a mid-cycle recovery. We remain optimistic that stock market returns should continue to be positive. The shift to a mid-economic cycle is usually seen with positive returns for stocks but a pick up in price volatility. Inflation, taxes, and the Federal Reserve's (Fed) expected moves are areas of concern that we are monitoring closely.

Inflation continues to be a key topic for investors. Prices have started to moderate, but supply chain issues will likely cause the "transitory" or temporary prices to stretch longer in 2022. Many supply chain and logistical challenges should be sorted out but will persist through most of next year. Energy prices will also start to have an economic impact as higher fuel and natural gas prices are likely this winter. The weakness in oil prices last year caused a cycle of underspending, which has left inventory and production levels low, which is pushing prices higher today.

Potential tax rates changes had the attention of the market, since most people don't like paying higher taxes. The likely outcome of proposed legislation in Washington is that tax rates will increase for the highest earning individual and companies. There are a lot of details that still need to be addressed, so the precise impact is still unknown. There have been some who speculate that higher taxes are going to end the stock market rally. Looking back at previous tax increases, there is not a lot of evidence to support this thinking. In the six months before a tax increase, there has been a temporary decline in the market of less than 5%, but not a significant reversal. In the six months after taxes increases, markets have seen low double-digit returns. So there is likely to be some near-term noise around tax hikes but the market moves higher in the long term. Tax increases are not a market issue but an economic issue.

The final area we are watching are actions from the Fed. The Fed indicated they are open to withdrawing some of the emergency policies they put in place in March 2020. These policies are primarily buying $80 billion of treasury bonds and $50 billion of mortgage bonds each month. They should start to taper their purchases in November and stop any additional purchases by the middle of next year. There is some anxiety around this change because there is a fear that interest rates may jump if the Fed stops buying. The last time the Fed tapered their purchases in 2013, interest rates drifted lower over the next year. Even with the Fed removing their asset purchases, they will remain accommodative by keeping interest rates low in the near term. The expectations are that rate increases will come in 2022 but will still be historically low for the medium term.

Given inflation, taxes and the Fed, why are we optimistic about stocks over the next year? We think that earnings growth, consumer spending and stock buybacks will help stocks continue to perform. Corporate earnings are expected to grow 42% for the 2021 calendar year and around 10% next year. Most of the market returns seen this year have been because of corporate earnings, and we expect that to continue. Next year's earnings expectations are a sign that we are moving towards a mid-cycle economic growth. The robust earnings growth this year has helped bring the market P/E down from 22.3 to 20x, which is still above average 16.4x 10 year average but looks more reasonable.

Consumers in the US and around the world are in the mood to spend and have the resources to do so. Savings rate and average account balances are at recent highs. Globally savings rates are 15% higher than they were in 2019. The wealth effect created by gains in the stock market will also help lift spending for the following year. Companies are also looking to spend. It is projected that the next 12 months could see a record level of stock buybacks from companies. This is a short-term catalyst for share prices increases.

We have mentioned a shift from an early market cycle growth to a mid-cycle market growth several times. The second year of bull markets look very different than year one. The chart below shows that returns in the first year of a bull market are excellent, with an average performance of over 40%. Year two is still historically great but does not keep pace with the year one returns. Corporate earnings and economic growth will downshift from year one to year two, explaining some of the performance differences. The other thing you'll see is more volatility or price movement in the second year. It is not unusual to see a 10% or greater sell off in year two of a bull market.

Stocks should continue to provide solid returns for the next 12 months. We are confident that things will not look as strong as the last 12 months but this should not discourage you or cause a change in allocation.

Andrew Comstock, CFAPrincipal - Wealth Advisor — *Andrew Comstock, CFA*
*Principal - Wealth Advisor*

US Market Viewpoints Q3 2021