Monthly Outlook: October 2021 

Markets took a breather in September after many months of grinding higher. The S&P500 sagged 4.7%, the NASDAQ dropped 5.6%, and the international stock index, EAFE, fell 3.3%. Bonds, usually a safe haven, were also soft, losing 1.0%. The good news is that the long-term trends of stocks and bonds remain upward and so we must call this just a normal correction for now. Will investors buy the dip again, or is there something else going on? We’ll consider the possibilities, below.

I often use the expression, “When in doubt, zoom out.” It’s helpful to step back from the immediate view and consider the bigger picture that includes historical context and more inclusive framing. Today’s stock and bond market is really the culmination of stimulus policies and economic recovery since the 2008 Financial Crisis. Congress and the Federal Reserve (the Fed) have poured massive amounts of fiscal and monetary stimulus into the system. The list of programs reads like alphabet soup: Economic Stimulus Act, QE1, QE2, American Recovery Act, PPP, QE Infinity, and on and on. With COVID, stimulus programs have gone to warp speed and piled on to the last decade’s programs at an exponential rate. Even today, with COVID nearly two years old and waning, Congress is pushing for a $1 trillion dollar infrastructure bill and a $3.5 trillion dollar programs bill. At the same time, the Fed can barely agree to finally start tapering some of their bond-buying stimulus program.

These stimulus programs have occurred through three U.S. Presidents of both major parties, and through three Federal Reserve Chairpersons appointed by different Presidents. My point is that stimulus is not a one-sided, partisan issue. The difficult question is how has thirteen years of unprecedented stimulus worked? How much stronger is the economy as a result? And what impact did it have on financial markets, in particular the stock, bond, and housing markets? Even former Fed Chairman, Alan Greenspan, clearly admitted in 2012, that on the issue of the quantitative easing (QE) program, “there was very little impact on the economy.” But what is irrefutable, is that the combined effect of a decade-long chronic stimulus addiction has driven stock markets to the highest valuation levels in history. Whether we look at Price to Earnings (P/E) or Total Market Capitalization to GDP (TMC/GDP), this stock market is expensive! I suspect that we’ll look back at this period in history and call this the “Stimulus Bubble”, like the “Tech Bubble” of 2001 and the “Housing Bubble” of 2007. To be clear, I’m not sure how long this bubble will continue to expand or when it will pop. After all, it’s been building for a decade so why couldn’t it continue? The point to consider this month is that since the bubble was created by the Fed and stimulus programs, I strongly suspect that it will be the Fed that will pop its own bubble through a change in policy. So far, investors have supreme faith in the Fed and its ability to pump the markets with more “free money.”  The rally cry is “The Fed has our back and won’t let the market go down.” But what would force the Fed to take their foot off the gas, a move that would disappoint investors?

The Fed is tasked with creating full employment and keeping inflation in check. Today, the unemployment rate has recovered back to a low 5.1% unemployment rate. Inflation is clearly present but so far, the Fed calls it “transient” and expects it to be short-lived due to temporary imbalances of supply and demand. But inflation is becoming more persistent and that is worrisome. The big questions, therefore, are these: Will the Fed be forced to reduce its stimulus to squelch inflation? What if the gig is up for free money to fuel stock prices higher? What if they make a policy error by going after persistent inflation when it turns out it was only transient? The Fed could trigger a recession and bear market for stocks by their own doing. It’s happened before (policy errors).

None of these concerns are true today. They’re just the conversation in my head when I “zoom out” and consider the possibilities. The right course of action for us as money managers is to stay optimistic, yet vigilant. We’ll stay invested but willing to sell if stocks move below their 200-day moving average trend line (our line in the sand). Being prepared doesn’t make us bearish or pessimistic. Whether this bubble pops in a month, in a year, or never, it’s just prudent to have a plan and the discipline to use it.