Market Changing Leadership

By Ketu Desai

While it may be hard to tell, most of the market has been consolidating for the bulk of the year. The broader Russell 2000 has been range-bound since February. The average S&P stock is down 13 percent, average Nasdaq stock down 15 percent, and average Russell stock down 29 percent. The S&P and Nasdaq have been masked by a few large cap stocks. The rolling correction started to hit those large cap stocks in September. If history is any guide, these stocks are usually the last to get hit during a rolling correction. If this is the last phase, once it is over, we should be set for a broader and more sustainable rally with small caps likely leading.

Historically, every cycle has brought new leadership. The Great Financial Crisis shifted leadership from large banks, industrials like GE, and energy companies like Exxon to the large cap technology stocks. The tech stocks were joined by other areas that benefit from low inflation and the bull market in bonds like utilities, real estate, and certain healthcare and biotech names. This cycle is also likely to bring new leadership. I think we caught a glimpse of the leadership from last November to about February / March this year. Since about February / March, COVID concerns have driven the market, and the market retreated to the previous cycle's leadership. We may be on the verge of turning the corner to the new leadership for this cycle. This cycle will likely bring higher rates and higher inflation than the previous cycle. Technological innovation will help prevent runaway inflation. However, higher inflation will be driven by onshoring, changes in energy supply and infrastructure, higher government deficits and spending, and labor shortages leading to higher wages.

The transition to clean energy will be a big driver of the next cycle. This transition is inflationary given its demand for commodities, infrastructure, and labor. This all favors hard assets and commodities that will facilitate these changes. Value-oriented sectors such as energy, materials, industrials, and financials all stand to benefit. These sectors are also among the cheapest in the market and are likely to be able to withstand higher rates. Value stocks are in the 10th percentile of relative valuation versus growth, cheaper than the dot-com bubble. The growth side of the portfolio will have to have large enough growth to withstand higher rates. Areas that look to be able to do so are fintech and crypto, biotech, artificial intelligence, and clean energy. Other parts of the market such as large cap tech and pharma, utilities, and staples are likely to get some reallocation from bond portfolios and serve more as risk-off assets with more muted returns.

In a volatile month, there were some notable events that might spark the change in leadership. The Fed strongly signaled that they will announce the taper at their next meeting in November. Most expect them to taper $15bn / month, which would end mid-2022. After which we can start talking about rate hikes. In general, there has been a more hawkish tone from central banks around the world. The hawkish tone along with an improvement in the economic data and better COVID trends sparked a move up in yields. Many travel restrictions are starting to come off. China has been pumping liquidity into their system and the US looks like it will pass more stimulus. Germany and Japan are going to have new leadership that could bring more fiscal stimulus. The building blocks are coming into place for new market leadership.

Looking forward the market will focus on third quarter earnings and economic data, and the latest in Washington, China, and COVID.

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Ketu Desai is the Principal of i-squared Wealth Management Inc. ( www.isquaredwealth.com ), an investment management firm based in New Jersey. ketu@isquaredwealth.com