Q2 Market Report
By Matt Johnson, CFA® and Andy Nugent, CFA®
Market Recap, Portfolio Analysis, and Review
The second quarter saw COVID-19 restrictions drop significantly in the United States, which meant many venues opening to full capacity. Concerts and sporting events drew large crowds as people were ready to get out and socialize after a year of being locked down. Consumers were not just spending on entertainment, but also on discretionary items like cars and construction projects. Demand in these areas was so large it caused transitory inflation in a few areas that saw prices skyrocket. In addition, due to the very generous Biden COVID Stimulus Package, unemployment benefits have increased for those on unemployment through September. Many small businesses with lower-paying job openings are finding it difficult to fully staff to handle the strong demand.
At the end of the day, the reopening caused quite a few growing pains and transitory inflation; however, interest rates remain low, the dollar is strong, and unemployment, although still a bit high, is down significantly from the 2020 peak. Most importantly, the publicly trading companies continue to generate near-record earnings and the stock market marches higher. After advancing over 5% in the first quarter, the market continued its rally by gaining an additional 8% in the second quarter.
As we have said previously, while it would be terrific to advance more than 5% every quarter, we do not expect market growth to continue consistently at these higher levels. While low interest rates and a strong reopening should help keep the equity markets testing new highs, don’t be surprised if you see a pullback should the market get ahead of itself.
What is transitory inflation? It is inflation that is short term in nature. It occurs when we see months of higher prices due to pent-up demand and supply chain shortages. Some of these cycles are shorter-lived than others. In May, the price of lumber was up nearly 400% from a year earlier, making new construction costs extremely expensive and contributing to the rising real estate market. However, from the May highs, we have seen lumber prices cut in half from the unprecedented levels. This short spike in prices was due to simple supply and demand. When demand for lumber was low in 2020 due to the pandemic, the mills produced less. As demand increased this year, it took a little while for supply to catch up.
Car prices have also increased dramatically for both new and used vehicles. These higher prices will linger longer than the lumber shortage, but will likely see some relief by the end of the year. A number of factors are driving up prices due to both supply and demand. As businesses are opening and having employees come back to work, many who put off the purchase of a new car are buying now. In addition, of those that did keep their jobs through the pandemic, many have more in savings as they did not spend as much in 2020 with the economy closed. Add to that a chip shortage, which is having a large impact on the production of new vehicles, leading to low dealer inventories and prices rising sharply. This has caused a significant increase in prices for used cars as well. Once production increases and the pent-up demand subsides, we will likely see prices normalize.
THE U.S. $ and Interest Rates
Interest rates remain at relatively low levels from a historical perspective. The 10-year Treasury Note sits at 1.45% at quarter end. While this is low considering long-term numbers, it is up from a yield of just under 1% at the beginning of the year, but down from 1.74% seen at the end of last quarter.
It seems unlikely that we would see the U.S. dollar strengthen in these current conditions. With all of the stimulus spending, it is difficult to see how the dollar could get stronger; yet as the U.S. interest rates are relatively high compared to the rest of the world, we see an increase in foreign demand for treasuries.
As a reminder, a strengthening dollar is good for U.S. businesses when it comes to buying materials that are made internationally. However, for companies with global distribution of U.S. goods, prices will become more expensive for the foreign consumer. As the U.S. dollar is just starting to strengthen, it shouldn’t have a large impact on companies’ earnings, yet something to keep an eye on as we move through the year.
We continue to be very cautious on bond investments as new purchases will continue to have low yields, and if interest rates rise, the price of existing bonds will decline. As such, when we do purchase a bond, we are focusing on short-duration instruments with the hopes of rolling that money over into higher yields in the future. We are also utilizing preferred equities as bond proxies to increase yields as dividends received are higher than bond rates, and the prices are more stable than common equity.
2021 began the year with unemployment at 6.7%. Through the year, the rate ticked down to 5.8% at the end of May, but actually increased by the end of June to finish the quarter at 5.9%. While this is a bit surprising considering that many businesses cannot fill current job openings, we may need to consider the many people who are not looking for work due to the enhanced unemployment benefits. Other than a sense of pride, it is understandable that people would not come back to the job market if they are making the same amount from unemployment. These benefits are expected to end in September, so barring an extension of the benefits, we would expect to see a further decline in the unemployment rate as we head toward the end of the year.
The turnaround in interest rates was very positive for this sector and they did market perform with about an 8% return in the second quarter. It is important to note that while interest rates were rising, the stocks in this sector were looking ahead to continued rate increases and pricing the companies accordingly. In the last month, we have seen a dip in the 10-year rate, and as such, financials lost over 3% in May. This is a sector that will rise and fall with rates, and although the future looks promising if you assume rates will eventually go higher, the companies within this sector are a bit ahead of themselves. We will wait for the prices of companies to pull back before investing.
Energy continued a solid 2021 by returning over 10% in the second quarter after being the best performing sector in the first quarter. Keep in mind, this rebound is coming off a dismal 2020 in which it lost 37% of its value. That said, after having a glut of oil in 2020, the U.S. was not ready for such robust demand in 2021, causing oil prices to increase significantly, mostly due to a truck driver shortage and an inability to transport the oil where it needed to go. While oil prices rose above $70 a barrel (up from as low as $47 a barrel in the beginning of the year), we feel this price increase is transitory and you will see the price of oil back off toward the end of the year.
After taking a breather in the first quarter of 2021, information technology got back on track and was one of the top-performing sectors in the second quarter advancing over 11%. We still like IT for the long term, but repositioned a bit selling chip makers Intel and Broadcom as their prices exceeded our estimate of their worth. We did add two new names in the quarter: Adobe and PayPal were added to the portfolio. Both companies continue to grow revenue and earnings at a significant rate and are leaders in their respective fields, and we expect that to continue.
This remains an area we like and are looking to invest more when opportunities present themselves. The sector did underperform a bit in the second quarter, but did have a positive 3% return. We added to our exposure in this sector during the quarter purchasing the spice company McCormick. This is a quality play as they are one of the leaders in their area and maintain very solid cash flows and balance sheets. We feel McCormick offers a reasonable return with limited downside due to its stable sales and earnings through the years.
Healthcare is another area we like, and so have invested about 15% of our equity holdings in this sector. In the second quarter, it market performed with a return of about 8%. When you combine this with the above-average dividend yield (many between 3-4.5%), we think this is a good place for the medium to long term. We hold high-quality names such as Johnson & Johnson, Pfizer, Bristol-Myers, and AbbVie, and we continue to look for opportunities in this area.
The second quarter was very strong; a market gain of 8% in any quarter is a win. While technology companies got back on track, many industries had price spikes that we believe are short term in nature. The markets are near record highs. It seems growth and value are taking turns increasing in price. We are not constrained to invest in any one style, which allows us to buy both growth and value companies as we did this quarter, purchasing PayPal and Adobe as growth companies and McCormick with more of a value tilt. With the markets at current high levels, we are being very diligent with investment decisions. We are closer to selling a few names than buying, but continue to hunt for companies with good upside potential in which to invest. As long as these companies continue to grow income and cash flow, they should continue to march higher over the long term.
The market has been headed up since the March 2020 low. While this is fantastic, we want you to be ready if the market dips. Although we expect it to dip at some point, we are not going to try to time the market. If we do see stocks pull back, we will likely add to our positions or buy new ones. Keep a long-term focus and ride through any bumps in the road. As always, remember that we remain diligent and look to make investment decisions with your long-term financial wealth in mind.
About SAGE Capital Advisors
Sage Capital Advisors, LLC is an independent fiduciary and fee-only financial advisory firm headquartered in San Diego, California. Operating as a boutique firm since 2005, Sage Capital Advisors puts their clients’ interests first in all things and gives personalized attention so their clients can experience financial peace of mind. Providing a full range of investment and wealth management services, the Sage Capital Advisors team prioritizes integrity, due diligence, transparency, and customized strategies based on their clients’ individual situations and goals. To learn more about Sage Capital Advisors, connect with them on LinkedIn or visit their website.