by Liz Ann Sonders, Chief Investment Strategist, Charles Schwab & Company Ltd.
The year so far has been a stellar one for equity investors, but mostly associated with major market averages like the S&P 500, which has been up for seven consecutive months. There have been 54 new closing highs for the S&P 500 so far this year. As shown below, that puts this year so far in fourth place (2017 and 1964 were tied) in terms of the number of new closing highs (by calendar year) over the full history of the index.
Closing Highs Per Year
Source: Charles Schwab, S&P Dow Jones Indices, 1926-2021. *YTD thru 9/3/2021. Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. Past performance is no guarantee of future results.
“The market”
Headlines have been abundant about the resiliency of “the market” given myriad concerns about COVID’s delta variant and weaker-than-expected economic data recently—notably sinking consumer confidence and the very weak August jobs report. Speculative froth has also been prevalent as a market risk all year; and here is where we connect the dots of what “the market” has done and where speculation has been most significant.
It is true that a “benchmark” index like the S&P 500 (blue line) has performed quite well since it bottomed in March 2020. However, there has been significantly more carnage in the segments of the market that have seen the most speculative froth. The chart below tracks drawdowns from peaks going back to the beginning of 2020. The blue line represents the S&P 500, which has had minimal drawdowns since it bottomed in March 2020.
The yellow line is an amalgamation of some of the non-traditional segments of the broader market which have seen the bulk of speculative fervor. It includes the two most popular meme stocks, non-profitable “tech” stocks, SPACs, Bitcoin, heavily shorted stocks, and recent IPOs. There have been significant drawdowns in these stocks this year, amid much higher volatility and larger swings relative to an index like the S&P 500. Collectively, although rising again recently, they remain well below their pre-pandemic, and post-lockdown highs.
Not All “Markets” Have Been Resilient
Source: Charles Schwab, Bloomberg, as of 9/3/2021. GS non-profitable tech basket consists of non-profitable U.S.-listed companies in innovative industries. Technology is defined quite broadly to include new economy companies across GICS industry groupings. ISPAC Index is a passive rules-based index that tracks the performance of the newly listed Special Purpose Acquisitions Corporations (“SPACs”) ex-warrant and initial public offerings derived from SPACs since August 1, 2017. Goldman Sachs (GS) most-shorted basket contains the 50 highest short interest names in the Russell 3000; names have a market cap greater than $1 billion. Renaissance IPO Index is a diversified portfolio of U.S.-listed newly public companies that provides exposure to securities under-represented in broad benchmark indices. Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. Past performance is no guarantee of future results.
Leaving aside the highly speculative segments of “the market,” since the pandemic erupted, there have been several key phases in terms of market leadership—at least in terms of the S&P 500. To a significant degree, those phases have tended to be guided by COVID trends. The first major phase was from the March 23, 2020 low until September 2, 2020. The second major phase lasted until the end of March this year, and the third major phase may have recently morphed into a fourth phase.
Phase one
As shown in the S&P 500 sector- and style-based performance charts below, the first phase was dominated by the Technology and Consumer Discretionary sectors. Those two sectors housed three (Apple, Microsoft, and Amazon) of the “Big 5” stocks that utterly dominated performance in 2020 through September 2 that year (the other two are Facebook and Google, both of which are in the Communications Services sector).
It was a unique phase in the sense that the aforementioned stocks were the pandemic/lockdown era’s “defensive” stocks. Those stocks, among other leaders, are generally “housed” in the growth indexes, and as such, the Russell Growth indexes (both large cap and small cap) handily outperformed the Russell Value indexes.
Phase One Performance
Source: Charles Schwab, Bloomberg, as of 9/3/2021. Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. Dividends and interest are assumed to have been reinvested, and the examples do not reflect the effects of taxes, expenses, or fees. Past performance is no guarantee of future results.
Phase two
The second phase, from early-September 2020 through the end of March this year, included a couple of mini-phases. There was a consolidation phase in September/
October 2020, driven in part by both the resurgence in the virus, but also election-related uncertainty. Then the positive vaccine news began filtering in in early November, and the market’s leadership shifted significantly toward traditional cyclicals like Energy, while Financials also found a bid courtesy of the steepening yield curve. As shown in the first chart below, the winners from the first phase were left in the dust in relative terms—not just Technology and Consumer Discretionary, but the classic defensive sector of Consumer Staples.
Energy and Financials largely live within the value indexes—with Financials representing about 28% of the Russell 2000 Value Index at the start of that phase. As shown in the second chart below, small cap value trounced all other style indexes—especially large cap growth, which barely made it into positive territory.
Phase Two Performance
Source: Charles Schwab, Bloomberg, as of 9/3/2021. Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. Dividends and interest are assumed to have been reinvested, and the examples do not reflect the effects of taxes, expenses, or fees. Past performance is no guarantee of future results.
The second phase ended, and the third phase began, alongside the peak in the 10-year Treasury yield. Yields reached nearly 1.75% on March 31, 2021, after hitting a low of 0.50% in early August 2020. The spike in yields—and attendant inflation risk—during that phase put significant pressure on higher valuation segments of the market. This is because when bond yields rise, the cost of capital rises as well. That means future cash flows get discounted at higher rates, which compresses equity valuations—especially in areas where they’re the most elevated.
Phase three
The bond yield high of nearly 1.75% at the end of March was followed by a steady descent to below 1.2% in early August this year. This was due to the bond market pricing in a Federal Reserve which would begin to talk about tapering its balance sheet purchases (of Treasury and mortgage-backed securities). As shown in the first chart below, lower yields provided the initial tailwinds for Technology and Consumer Discretionary, but also the interest-sensitive Real Estate Investment Trusts (REITs) sector. In turn, Energy and Industrials have been left in the relative dust.
As shown in the second chart below, large cap growth has again found its way to the top of the leaderboard—but it’s been more about cap size than growth, given that small cap growth (and small cap value) significantly underperformed.
Phase Three Performance
Source: Charles Schwab, Bloomberg, as of 9/3/2021. Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. Dividends and interest are assumed to have been reinvested, and the examples do not reflect the effects of taxes, expenses, or fees. Past performance is no guarantee of future results.
The leadership by the REITs sector during phase three was enough to catapult it to the top of the leaderboard for 2021 year-to-date, followed close behind by Communication Services, Financials, and Energy. Notwithstanding some recent bursts of outperformance, the classic defensive sectors of Consumer Staples and Utilities are bringing up the rear. In terms of the ever-popular Technology sector, last week marked the one-year anniversary of the sector’s relative strength peak vs. the S&P 500.
YTD Performance
Source: Charles Schwab, Bloomberg, as of 9/3/2021. Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. Dividends and interest are assumed to have been reinvested, and the examples do not reflect the effects of taxes, expenses, or fees. Past performance is no guarantee of future results.
Speaking of cap
During the latter part of phase three, there was an underlying shift that took place at the cap level. The chart below has bars representing two snapshot dates for the S&P 1500 (a larger universe of stocks than the large cap-biased S&P 500). The blue bars show the percentage of stocks above their 200-day moving averages by market cap decile as of March 12 this year. That date represented the inflection point when large caps began outperforming small caps. Prior to that, small caps had staged an impressive run, which was tied to the “economic reopening” theme associated with the pandemic. Small caps tend to be more cyclical and “leveraged” to an improving economy, hence their outperformance for most of phase three.
Fast forward to the present, and the breakdown of performance by market cap is decidedly different. The yellow bars in the chart below are as of last Friday, and the picture is a mirror image relative to March—with the largest stocks significantly outperforming the smallest stocks. This is mostly due to a pricing in of a more uncertain economic outlook.
Cap Switch
Source: Charles Schwab, Bloomberg, as of 9/3/2021. Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. Past performance is no guarantee of future results.
Another (seasonal) phase in the works?
Perhaps right on cue as per last year, concerns are elevated again about seasonal tendencies. Not only is September the worst month historically for returns, the combination of September and October has historically been the worst two-month period among all others. Using the Dow Jones Industrial Average—which has a longer history than the S&P 500—the table below shows that the September/October span has been up less than half the time, with the lowest average return (in negative territory).
Source: Charles Schwab, SentimenTrader. 1900-2020. Table looks at performance achieved by holding the Dow every year but only during the indicated starting and ending months. Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. Past performance is no guarantee of future results.
For the S&P 500, September has also been the month during which there have tended to be the fewest new highs. That said, the index has plowed right through every negative thrown its way this year. As noted by our friends at SentimenTrader (ST), seasonality is a tertiary factor. For what it’s worth though, ST looked at every year when the S&P 500 closed the month of August at an all-time high, and subsequent performance was quite weak. Of the 15 prior occurrences, one month later, there were only 20% positive returns, with a median return of -1.6% and a poor risk/reward profile.
In fairness, the worst Septembers historically came with the S&P 500 was already trending lower—clearly not the case this time. In addition, some of the worst drawdowns during Septembers/Octobers have also provided major buying opportunities (think Crash of ’87). No historical trend should be considered as a market timing tool, including seasonal tendencies, but they can be reminders to assess portfolio risks.
Sector volatility
The three phases noted above had major differences in terms of sector leadership. But even within those phases, volatility was rampant. Many readers may be familiar with the look of the visual below. Typically, we show an asset class “quilt,” with broad equity/fixed income asset classes, ranked by performance on a yearly basis. The version below covers the 11 sectors of the S&P 500 and ranks performance by month.
The conclusion investors should make when glancing at this quilt is that just like asset classes move in and out of favor each year, sectors can move in an out of favor even more quickly. The point of these quilts is about the power and benefits of diversification. We expect sector volatility and leadership shifts to persist, which is one of the reasons we only have one “outperform” rating among the sectors (Health Care). For more on that, and the latest on all of our sector views, see David Kastner’s most recent commentary: Schwab Sector Views: Too Early for Defensive Positioning | Charles Schwab
Source: Charles Schwab, Bloomberg, as of 8/31/2021. Sector performance is represented by price returns of the following 11 GICS sector indices: Consumer Discretionary Sector, Consumer Staples Sector, Energy Sector, Financials Sector, Health Care Sector, Industrials Sector, Information Technology Sector, Materials Sector, Real Estate Sector, Communication Services Sector, and Utilities Sector. Returns of the broad market are represented by the S&P500. Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. Dividends and interest are assumed to have been reinvested, and the examples do not reflect the effects of taxes, expenses, or fees. Past performance is no guarantee of future results.
In sum
Given shifting phases of leadership, rampant sector- and style-related volatility, economic uncertainty driven by COVID, monetary/fiscal policy uncertainty, and seasonal tendencies, we believe investors should focus on the tried-and-true disciplines of diversification (across and within asset classes) and periodic rebalancing. For stock-pickers out there, we have been highlighting all year a bias toward factors over sectors. In particular, we think the focus should be on quality (blending both value and growth-oriented factor analysis). Rebalancing is particularly important when volatility picks up, as it “forces” investors to trim into strength and add into weakness.
Copyright © Charles Schwab & Company Ltd.
