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Q3 Market Review and Outlook

Market Review and Outlook

Fall time has arrived and here is our 3rd Quarter review and stock market outlook letter. The photo above
was taken by myself as I was recently hiking in Lockett Meadow northeast of Flagstaff. I love the fall time
as the leaves begin to change colors and the summer heat begins to loosen its grip on the Arizona
desert. This hike was refreshing and I encourage all to get out and see the beautiful Arizona outdoors as
the temperatures are very pleasant for the time being.

A lot has happened between now and our last market update report. Just as the fall brings a change in
the weather as summer eventually gives way to cooler temperatures, there are changes coming about in
the stock market that are worthy of discussion.

The market has performed well overall this year although the returns have not been evenly spread
through all asset classes that we track

Market Performance for Q3 2021

Index Returns as of 9/30/21




In general, stocks are positive for the year and bonds are negative. This means that, in general, investors
are in the mood for risk-taking and expect good economic developments going forward. Investors are net
sellers of bonds which means they clearly don’t see a need to hold stable and safe investments in their
portfolios. Also, investors have an appetite for smaller, riskier stocks that perform well in times of
prosperity even though they are more vulnerable during times of economic recession. The takeaway here
is that investors definitely expect the good times to continue.

Another general fact is that investors have loaded up on U.S. stocks and have been much more hesitant
about buying non-U.S. stocks. Stocks outside the U.S. have more risk but are under-performing U.S.
stocks. Investors don’t believe non-U.S. stocks are worth the risk right now

Q3 Summary

The S&P 500 Index was positive for the quarter as the reopening of the economy mentality persisted amond large investors. Consumer activity remained healthy as numbers indicated that families are still in a spending mood. Total retail sales for the second quarter (announced in August 2021) came in at $1.67 Trillion, a healthy 5.2% compared to the first quarter of 2021. What is astounding about this number is that is 28% higher than the same period in 2020!
Total retail sales for the third quarter of 2021 were up 14.9% versus the third quarter of 2020! These are gigantic jumps in retail sales growth

You might have expected the stock market to skyrocket after these kinds of economic readings. How did
the stock market actually respond to these numbers?

In July the S&P 500 Index was up about 2.4%, up about 3% in August, and then down 4.7% in
September. The market definitely took on a different tone in September as nearly every sector sold off.

What I find interesting is that retail stocks like Amazon.com, Wal Mart, Target, etc. did not perform well
during the 3rd quarter at the same time these robust retail sales growth numbers were being reported.
Here is how some popular general retail stocks fared:


Amazon.com (AMZN)
Wal Mart (WMT)
Target (TGT)
Best Buy

Price Change

And the poor performance wasn’t limited to just these few. The S&P Retail Sector ETF (XRT), which owns 107 different retail-related stocks, was down -6.84% for the quarter. There seems to be a huge
disconnect between the retail sales growth data reported by the federal government and investors
enthusiasm for retail stocks. It seems that investors have soured on the whole group. What gives?

This could be due to seasonality factors (the market almost always turns negative in September and
October). But there were other factors at play as well. One of the things that is worrying investors is the
prospect that the level of retail sales growth may be creating some problems.

Are you prepared for long-term inflation?

We all knew this was coming and here it finally is. Inflation! We don’t typically see huge inflation readings in a short period of time. Usually price inflation happens gradually as the economy grows and household incomes grow at a fairly rapid pace. Gradual inflation over a long period of time is to be expected as it is a natural result of sustained periods of economic prosperity. Inflation isn’t too harmful as long as it remains in the range of 2%-3% per year.

The problem with inflation is that is essentially a tax on everyone.

As prices on goods and services increase it takes more and more dollars to afford the same volume. Consumers can afford a little inflation as long as their incomes increase at a corresponding rate. Real problems arise when household incomes stay stagnant and prices keep rising. If inflation is persistent then consumers have to eventually make major adjustments to their budgets. The result of long-term inflation is economic recession as things become unaffordable to consumer and GDP growth will turn negative at some point.

Where Do We See Inflation?

Oil and gas prices have a history of responding very quickly to rises in consumer spending. That’s because economic growth can’t happen without fuel. Factories can’t increase the manufacture of more goods and ship them around the world without an increase in the production of fuel. The cost of fuel has an impact on everything we do. It’s even built into the cost of the food we eat. Oil and gas producers keep a close watch on the changes in fuel inventories.
The Covid pandemic in early 2020 had a punishing effect on oil and gas producers as people all around the world were ordered to stay home for a time. Travel basically came to a standstill and major roads and highways suddenly become nearly empty. But as the economy has reopened the price of oil has skyrocketed. Below is a graph from the Bureau of Labor Statistics showing the year over year increase in energy prices (oil and gas) from September 2020 through September 2021.
What led to the big change? Travel still hasn’t recovered. Highways aren’t completely full like they were before since many people still work from home.

Economic Fuel

To understand the forces pushing up prices in all areas of our economy we need to look back at the recession of 2007-2008 known as The Great Recession. This was the time that our nation’s banking system nearly imploded. What started out as a series of mortgage loan defaults by highly leveraged borrowers quickly escalated into a real estate market crash after a recession pushed more and more homeowners to abandon homes and default on their mortgages. A few large financial institutions failed such as Washington Mutual, Lehman Brothers, and Bear Stearns. The huge recession led to a massive deflation in the price of risky assets (stocks, real estate, etc.).
The Federal Reserve Bank intervened in the financial system to avoid a total collapse. To thwart a true depression the Fed began injecting the U.S. economy with large amounts of capital under several stimulus programs called “Quantatative Easing” (aka printing money). The size of these programs was enormous. The first was QE1 in November 2008 to the tune of $600 Billion. When that failed to work the Fed unleashed QE2 in November 2010 which was another $600 Billion. The markets reacted slowly and real economic growth was far below estimates during this time.
To fuel a reinflation of the economy (and the stock market), the Federal Reserve launched QE3 in September 2012. This program was a little different. The Federal Reserve Bank began purchasing $40 Billion of mortgage-backed securities (quasi-government bonds) to force interest rates lower and stimulate consumer borrowing. This bond buying program didn’t end until October 2014 and by this time the Federal Reserve had accumulated about $4.5 Trillion in government bond assets. By this time interest rates were nearly down to zero and the stock market had started a long recovery. The Federal Reserve had discussed reversing some of the stimulus programs in a gradual manner to avoid an overheated economy that would result in inflation.
But then the Covid pandemic hit the world. As the U.S. economy experienced shutdowns and many jobs were lost, the Federal Reserve quickly started QE4. They announced a $700 Billion stimulus program to purchase more bonds. This time, though, they bought corporate bonds which sank in record fashion when the stock market dropped 35% in a single month. This marked the first time the Federal Reserve had directly purchased anything other Federal Government issued securities. It’s charter actually didn’t allow for it was argued that drastic times called for drastic measured. By mid-summer of 2020 the Federal Reserve had actually purchased an additional $2 Trillion of bonds from the bond market! These are absolutely enormous amounts of capital poured into the U.S. economy through government intervention and the printing of money.
You might be wondering what the point is for this stroll back in history? The purpose of all of these massive stimulus programs was to reinflate the economy. Did it work? Yes. It took a long time but it definitely was successful. But now we are beginning to see the consequences and you should be aware of what is likely right ahead of us.

Economic Fuel

The impact from all of the stimulus programs from 2008-2020 is going to be long-term inflation unless the Federal Reserve can begin to undo the quantitative easing programs from the past decade. Inflation is now beginning to greatly impact the real economy. We are seeing it in rising food prices, price of new and used vehicles, basic materials used in construction, etc. If you own a home you’ve seen a huge increase in the price of your home. If you rent then you’ve noticed a huge increase in your housing expense.
Just look at some of the annual rent hikes being experienced around the country. If this isn’t inflation then I don’t know what is

Next Stimulus?

If all of this inflation isn’t enough, we are on the precipice of another gigantic stimulus program to fund clean energy and massive social programs here in the United States. I’m not arguing for or against. I’ll remain apolitical in this letter. Various fund managers and economists I follow estimate that some kind of stimulus program will get passed before the end of the year. The size remains undetermined but could be between $1.5 Trillion and $4 Trillion. Doesn’t sound like much on paper but remember these are massive numbers.
The Clean Electricity Payment Program component of the proposed stimulus program is estimated to cost about $150 Billion. An independent study of the CEPP by an organization called Analysis Group estimates that “implementation of a CEPP through 2031 would generate over $907 Billion in economic value added, and create 7.7 million jobs”.
Ignoring the politics surrounding this stimulus program, what I foresee as a result is more money flowing throughout the economy. That also means much more inflation over the next decade or two.
As I said earlier, a little inflation is not a bad thing. Runaway inflation is different. When prices spiral higher more and more consumers become unable to afford the goods and services they want or need. The Federal Reserve knows this and at some point they will be forced to do something to try to control inflation. Will they act too late as they have historically done? I believe they will. They should be raising interest rates now and reversing some of the bond buybacks implanted over the past decade. But they are hesitant to do it because the Federal Reserve does not maintain political independence that it is supposed to have.

Global Economic Recovery

So far we’ve only discussed domestic sources of inflation. But keep in mind that the global economy is also experiencing a real recovery as well. Ports all over the world are experiencing huge backups as the volume of goods being purchased and produced and shipped to consumers has risen significantly over the past year. We have heard much about the logjam at the Long Beach, CA port. But Rotterdam, The Netherlands (the largest shipping port in Europe) is also backed up as volumes have surged 15% year over year.

So What’s The Playbook?

All of this begs the question, what does this mean for me as an investor? First, the stock market thrives on the prospects of higher future earnings generated by economic growth. And I think we are about to see a lot more of that. So the answer is to hold on to your stocks. For now.
Certain areas of the market are going to benefit more than others. Inflation hurts the extremely competitive industries like consumer staples: food retailers and utilities. Companies in these industries do have some pricing power but are not always able to raise prices enough to cover the increasing costs of their inputs which are inventory and labor. Keep in mind that minimum wages are rising and companies are paying more to their labor force to keep them around.
The areas of the market that are likely to thrive in this environment are financial institutions that make more money when the markets are rising. Banks earn more when they can lend at higher rates of interest. When the Federal Reserve tapers its bond buying programs and eventually hikes the federal funds rate then we will see banks really prosper.
Suppliers of raw materials and construction supplies are also expected to do well since they have pricing control and there is high demand for their products.
And the oil and gas industry is going to produce healthy earnings growth for the foreseeable future regardless of how much clean energy we gain over the next decade. This industry is Morningstar’s #1 pick right now.
Other notable fund managers at Fidelity, Vanguard, T. Rowe Price, Janus Henderson also expect healthy growth for the coming year or two. But beyond that inflation could cause some real problems.


All in all, I believe we are on a solid track for a robust fourth quarter 2021. My #1 goal remains the same: to help you retire as early as possible (or stay retired) with all the money you will need over your entire lifetime. I will continue doing that by being vigilant to changes in the market and your portfolio.

Don Larson, CFP®, MBA

About Me

Don Larson, CFP® is the owner and founder of Larson Wealth Management. Don started in the investment advisory industry in 1999 after he graduated from Arizona State University with a Bachelor of Science degree in Business Finance.

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