Executive Summary

Was the third quarter just a bull market pause? After two strong quarters to start the year, stocks were down slightly during the third quarter. Stocks began correcting in September after Federal Reserve Board (Fed) Chair, Jerome Powell, stated high inflation is lasting longer than expected, which is a slight change from previously describing it as “transitory” inflation. A big part of the spike in prices is constraints within the supply chain, which is still disrupted by the pandemic shutdowns, quarantines, and a lack of workers. Interest rates jumped after the Fed announcement and stocks declined with growth stocks leading the decline. As a reminder, higher interest rates affect valuations of growth stocks more, since their large future cash flows are worth less as they are discounted at a higher rate.

With a return of higher inflation (reflation) and an increase in yields, investors have moved funds to the reflation trade in September, and both value and small cap stocks have outperformed, building on the trend from the end of October last year. LTWM managed portfolios are tilted toward the value and size factor premiums to capture the higher expected long-term return. Let’s take a moment to review the historical returns of value vs. growth:

The above chart shows the average value premium since 1927 is 4.1%, however, in years when value outperformed growth, the average premium was over 14%. We also know that after a decade of growth out-performance, which we just experienced through the end of 2020, the average value premium the following decade has been 8.3% annually. We are optimistic about what may be the start of a long new trend.

The Fed is likely to be supportive for the bull market to continue through the last quarter of the year, but there are significant challenges, including high inflation, supply chain constraints, and the debt ceiling showdown by December 3rd, which could disrupt our government’s funding process. We remain cautiously optimistic.

For those who would like a deeper dive into the details, please continue reading…

World Asset Class 3rd Quarter 2021 Index Returns

U.S., International Developed, Emerging Market and Global Real Estate stocks were all down in the third quarter, a pause of the bull market trend that began on March 23rd of 2020 (the Covid bottom). U.S. Bonds were up 0.05%, while Global Bonds were up 0.09%, (basically flat) as the level of interest rates increased across longer maturities, while the very shortest, are still anchored to zero by the Fed. For the broad U.S. Stock Market, the first quarter return of -0.10% was below the average of 2.4% since January 2001. International Developed Stocks returned -0.66%, which was below the long-term average quarterly return of 1.7%. Emerging Market Stocks returned -8.09%, well below the average quarterly return of 2.9%. Global Real Estate Stocks returned -0.08%, below the asset class’s average quarterly return of 2.5%. While emerging markets had a few temporary issues, overall, stocks were very close to breakeven for the quarter. Here is a look at broad asset class returns over the past year and longer time periods (annualized):

The U.S stock market (as defined by the Russell 3000 Index) led all categories with a strong 31.88% return in the last year. Emerging Market stocks lagged with a return of 18.2%, International Developed stocks were up 26.5% over the past year, while Real Estate stocks were up 31.61% for the past year. Emerging Markets continue to have issues with the pandemic shutdowns and China had several country specific issues with tighter regulations and the failure of a large real estate company, Evergrande. Over the past five years, U.S. stocks were up 16.85% annually, while Emerging Market stocks were up 9.23% annually, International Developed stocks were up 8.88% annually, and Global Real Estate stocks were much less positive, up 4.65% annually since real estate was hit harder by the global pandemic. Over the past 10 years, the U.S. stock market (up 16.6% annually) is well ahead of International Developed (up 7.88% annually) and Emerging Market (EM) stocks, which are up 6.09% annually over the past 10 years. We continue to believe EM might be the place to be for the next 10 years, due to much lower valuations and higher growth trends.

A larger sample of global asset class returns during the third quarter shows how few asset classes had a positive return. U.S. Real Estate stocks (REIT Index), which have lagged in previous quarters, led all asset classes, while the S&P 500 and Russell 1000, both U.S large cap indices, also had a slightly positive return. Emerging markets struggled with a host of negative news out of China, including the government banning teens and children from playing more than 3 hours of video games per week, new data privacy laws that limit the ability of many ecommerce companies to collect and use customer information, stringent lockdowns to fight Covid outbreaks; and a series of real estate bond defaults, including holding companies Evergrande and Fantasia.

Taking a closer look within U.S. stocks in the third quarter, we can see that market wide results were down slightly, -0.1%, value underperformed growth in the U.S. across large cap stocks but value outperformed growth across small cap stocks; and small cap stocks underperformed large cap stocks.

As we have been pointing out in our previous quarterly commentary (https://www.laketahoewealthmanagement.org/news-notes/2021/4/9/market-and-economic-commentary-and-outlook, since the end of October last year, U.S. Small Cap Value has performed the best, and now it has the best one-year return (up 33.92% below). The return of inflation or reflation has improved the attractiveness of the trade for value stocks over growth, and more recently, the mega cap growth stocks, which represent the highest concentration since 2000, are leading the S&P 500 to underperform in October We discussed the difficulty of the largest stocks driving the index in our 2020 blog, “Will Tech Giants Continue to Dominate”, https://www.laketahoewealthmanagement.org/news-notes/2020/9/4/trhms8of4n47ivntkwefcit7czs7hs

International Developed Stocks were positive during the third quarter in local currency (below), outperforming Emerging Market Stocks, but underperforming U.S. stocks. Looking closer, the value premium (value-growth) was negative; while the size premium was positive (small cap stocks outperformed large cap stocks). The currency effect served as a headwind to international stock returns during the quarter, as US currency returns were lower than local currency returns. Our investment funds are priced in U.S. dollars and the dollar was strong during the third quarter.

While Value is better than growth YTD and one year for International Developed Stocks; over longer time periods, the value premium (value-growth) is negative for the past 3, 5 and 10 years. The size factor premium (small cap-large cap) is positive in the past three quarters and over the past 1, 3, 5 and 10 years. There is still plenty of room for value to catch growth over longer time periods in the future.

The U.S. economy is still in the early stages of a new business cycle, adding significant jobs each month with a declining unemployment rate and increasing employment wages, although we are likely past peak growth or rather, in a period of slower growth. The Conference Board’s Economic Index of leading indicators has been positive for the past year, signaling expectations of continued strength in the business cycle. Consumer demand is strong for long term purchases, including appliances, autos and residential homes, however, supply chain issues are dampening growth and increasing prices. The recent spike in prices should moderate as more supply constraints from reopening and filling entry level jobs are removed.

The euro area is still struggling to achieve a strong consumption rebound with slower than expected growth in the quarter. The United Kingdom is experiencing record gas prices and hopefully a solution is found prior to consumption pullbacks in other areas of the economy. The new Japanese government under Prime Minister Kishida has floated the idea of raising the capital gains tax, which dampened strong sentiment that he would be more market-friendly; and stocks in Japan have given back recent gains. Emerging markets had a more challenging quarter, due to several China specific policy decisions involving increased regulations; and bond defaults from major real estate holding companies. Multiple interest rate hikes in Latin America also contributed to the underperformance of emerging markets during the quarter.

Shifting the commentary to fixed income, bond market returns around the world were slightly positive due to a tightening of high yield spreads during the second quarter. The yield on the 5-year Treasury note increased by 12 basis points, ending the quarter at a yield of 1.0%. The yield on the 10-year Treasury note increased by 8 basis points, ending the quarter at a yield of 1.54%. And the 30-year Treasury bond yield increased by 3 bps to 2.09%. Here is the U.S. yield curve, and you can see how yields are barely over the past quarter (current yield curve in green, one quarter ago in blue, and one year ago in grey):

Notice below, the highest third quarter bond return is for TIPS (inflation protected bonds, up 1.75%), then the Bloomberg Barclays U.S. High Yield Corporate Bond Index, up 0.89% for the quarter and 4.53% YTD, which means investors are now worried about inflation but not economic weakness yet. With high yield spreads down around 3%, which is the lowest level since 2007, expectations for a strong economy are high. High-Yield spreads should reverse and start to widen when investors expect economic weakness. Here are the period returns:

The Federal Reserve has the delicate task of balancing inflation (price control) with economic growth to support employment or to make sure interest rates don’t rise too quickly, given all the past and proposed government stimulus. Any intervention by the Fed to increase short term rates earlier than expected or taper bond purchases more than expected may send stock prices down. So far, Fed Chair Powell has navigated market communication well and has prepared the bond market for the beginning of bond tapering at the next Fed meeting in November. However, the September jobs report, released on October 8th, was well below expectations and likely will allow the Fed more time to taper prior to raising the overnight lending rate and starting the rate hiking cycle. A longer tapering process and more distant rate hiking cycle will support stocks for a strong final quarter, as long as politicians are able to solve the debt ceiling impasse that was kicked down the road to December 3rd. The debt ceiling has been raised enough to move the deadline from October 18th, the day the government would exhaust its borrowing capabilities, to December 3rd. While we hope there is plenty of enthusiasm and time to solve the future funding of the government, it is likely to go to the last minute, which will cause volatility in the financial markets.

One cannot time markets and typically the short term is just noise. Here is a sample of how the world stock markets responded to headline news, during the last quarter and the last year (notice the insert of the second graph that compares the last 12 months to the long term). We encourage you to tune out the financial news, since major news sources have a bias toward negative headlines; and often the headlines of the day have very little to do with the direction of stocks.

CONCLUSION

Strong portfolio results through the first half of 2021, were put on pause during the basically flat third quarter. The Fed will be supportive for the strong results to continue through last quarter of the year, but there are numerous large potholes on the economic road to travel, including high inflation, supply chain constraints, and the normal functioning of our government’s funding process.

While we remain cautiously optimistic about the economic future, the best course of action is to focus on the decisions you can control to achieve the success of your financial plan. We continue to watch the potential tax changes closely and will be ready with recommendations.

We would like to share the results of a recent panel discussion on happiness in retirement. To summarize, there are three categories that lead to higher satisfaction in retirement: when you have enough money, strong relationships with peers and the community, and good health. Interestingly, while more wealth does make you happier, the research showed that happiness and wealth have a relatively linear effect up until about $4 million. After that, money does not lead to greater satisfaction.

Please reach out to us for a copy of the article or with any questions or concerns.

Standardized Performance Data and Disclosures

Russell data © Russell Investment Group 1995-2020, all rights reserved. Dow Jones data provided by Dow Jones Indexes. MSCI data copyright MSCI 2020, all rights reserved. S&P data provided by Standard & Poor’s Index Services Group. The BofA Merrill Lynch Indices are used with permission; © 2020 Merrill Lynch, Pierce, Fenner & Smith Inc.; all rights reserved. Citigroup bond indices copyright 2020 by Citigroup. Barclays data provided by Barclays Bank PLC. Indices are not available for direct investment; their performance does not reflect the expenses associated with the management of an actual portfolio.

The ICE BofAML Option-Adjusted Spreads (OASs) are the calculated spreads between a computed OAS index of all bonds in a given rating category and a spot Treasury curve. An OAS index is constructed using each constituent bond’s OAS, weighted by market capitalization. The ICE BofAML High Yield Master II OAS uses an index of bonds that are below investment grade (those rated BB or below).This data represents the ICE BofAML US High Yield Master II Index value, which tracks the performance of US dollar denominated below investment grade rated corporate debt publically issued in the US domestic market. To qualify for inclusion in the index, securities must have a below investment grade rating (based on an average of Moody's, S&P, and Fitch) and an investment grade rated country of risk (based on an average of Moody's, S&P, and Fitch foreign currency long term sovereign debt ratings). Each security must have greater than 1 year of remaining maturity, a fixed coupon schedule, and a minimum amount outstanding of $100 million. Original issue zero coupon bonds, "global" securities (debt issued simultaneously in the eurobond and US domestic bond markets), 144a securities and pay-in-kind securities, including toggle notes, qualify for inclusion in the Index. Callable perpetual securities qualify provided they are at least one year from the first call date. Fixed-to-floating rate securities also qualify provided they are callable within the fixed rate period and are at least one year from the last call prior to the date the bond transitions from a fixed to a floating rate security. DRD-eligible and defaulted securities are excluded from the Index,

ICE BofAML Explains the Construction Methodology of this series as:Index constituents are capitalization-weighted based on their current amount outstanding. With the exception of U.S. mortgage pass-throughs and U.S. structured products (ABS, CMBS and CMOs), accrued interest is calculated assuming next-day settlement. Accrued interest for U.S. mortgage pass-through and U.S. structured products is calculated assuming same-day settlement. Cash flows from bond payments that are received during the month are retained in the index until the end of the month and then are removed as part of the rebalancing. Cash does not earn any reinvestment income while it is held in the Index. The Index is rebalanced on the last calendar day of the month, based on information available up to and including the third business day before the last business day of the month. Issues that meet the qualifying criteria are included in the Index for the following month. Issues that no longer meet the criteria during the course of the month remain in the Index until the next month-end rebalancing at which point they are removed from the Index.

ICE Benchmark Administration Limited (IBA), ICE BofAML US High Yield Master II Option-Adjusted Spread [BAMLH0A0HYM2], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/BAMLH0A0HYM2, January 10, 2019.

Past performance is no guarantee of future results. This information is provided for educational purposes only and should not be considered investment advice or a solicitation to buy or sell securities. Diversification does not guarantee investment returns and does not eliminate the risk of loss.

Investing risks include loss of principal and fluctuating value. Small cap securities are subject to greater volatility than those in other asset categories. International investing involves special risks such as currency fluctuation and political instability. Investing in emerging markets may accentuate these risks. Sector-specific investments can also increase these risks.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, liquidity, prepayments, and other factors. REIT risks include changes in real estate values and property taxes, interest rates, cash flow of underlying real estate assets, supply and demand, and the management skill and creditworthiness of the issuer.

Principal Risks:

The principal risks of investing may include one or more of the following: market risk, small companies risk, risk of concentrating in the real estate industry, foreign securities risk and currencies risk, emerging markets risk, banking concentration risk, foreign government debt risk, interest rate risk, risk of investing for inflation protection, credit risk, risk of municipal securities, derivatives risk, securities lending risk, call risk, liquidity risk, income risk. Value investment risk. Investing strategy risk. To more fully understand the risks related to investment in the funds, investors should read each fund’s prospectus.

Investments in foreign issuers are subject to certain considerations that are not associated with investment in US public companies. Investment in the International Equity, Emerging Markets Equity and the Global Fixed Income Portfolios and Indices will be denominated in foreign currencies. Changes in the relative value of these foreign currencies and the US dollar, therefore, will affect the value of investments in the Portfolios. However, the Global Fixed Income Portfolios and Indices may utilize forward currency contracts to attempt to protect against uncertainty in the level of future currency rates (if applicable), to hedge against fluctuations in currency exchange rates or to transfer balances from one currency to another. Foreign Securities prices may decline or fluctuate because of (a) economic or political actions of foreign governments, and/or (b) less regulated or liquid securities markets.

The Real Estate Indices are each concentrated in the real estate industry. The exclusive focus by Real Estate Securities Portfolios on the real estate industry will cause the Real Estate Securities Portfolios to be exposed to the general risks of direct real estate ownership. The value of securities in the real estate industry can be affected by changes in real estate values and rental income, property taxes, and tax and regulatory requirements. Also, the value of securities in the real estate industry may decline with changes in interest rate. Investing in REITS and REIT-like entities involves certain unique risks in addition to those risks associated with investing in the real estate industry in general. REITS and REIT-like entities are dependent upon management skill, may not be diversified, and are subject to heavy cash flow dependency and self-liquidations. REITS and REIT-like entities also are subject to the possibility of failing to qualify for tax free pass through of income. Also, many foreign REIT-like entities are deemed for tax purposes as passive foreign investment companies (PFICs), which could result in the receipt of taxable dividends to shareholders at an unfavorable tax rate. Also, because REITS and REIT-like entities typically are invested in a limited number of projects or in a particular market segment, these entities are more susceptible to adverse developments affecting a single project or market segment than more broadly diversified investments. The performance of Real Estate Securities Portfolios may be materially different from the broad equity market.

Fixed Income Portfolios:

The net asset value of a fund that invests in fixed income securities will fluctuate when interest rates rise. An investor can lose principal value investing in a fixed income fund during a rising interest rate environment. The Portfolio may also be affected by: call risk, which is the risk that during periods of falling interest rates, a bond issuer will call or repay a higher-yielding bond before its maturity date; credit risk, which is the risk that a bond issuer will fail to pay interest and principal in a timely manner.

Risk of Banking Concentration:

Focus on the banking industry would link the performance of the short-term fixed income indices to changes in performance of the banking industry generally. For example, a change in the market’s perception of the riskiness of banks compared to non-banks would cause the Portfolio’s values to fluctuate.

The material is solely for informational purposes and shall not constitute an offer to sell or the solicitation to buy securities. The opinions expressed herein represent the current, good faith views of Lake Tahoe Wealth Management, Inc. (LTWM) as of the date indicated and are provided for limited purposes, are not definitive investment advice, and should not be relied on as such. The information presented in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, LTWM does not guarantee the accuracy, adequacy or completeness of such information.

Predictions, opinions, and other information contained in this presentation are subject to change continually and without notice of any kind and may no longer be true after the date indicated. Any forward-looking statements speak only as of the date they are made, and LTWM assumes no duty to and does not undertake to update forward-looking statements. Forward-looking statements are subject to numerous assumptions, risks and uncertainties, which change over time. Actual results could differ materially from those anticipated in forward looking statements. No investment strategy can guarantee performance results. All investments are subject to investment risk, including loss of principal invested.

Lake Tahoe Wealth Management, Inc.is a Registered Investment Advisory Firm with the Securities Exchange Commission.