Previous week's Weekly market wrap

Three Perspectives on Market Pullbacks

Last week started with a 700-point drop in the Dow, evoking the latest round of red chyrons and "market sell-off" headlines. By Tuesday they were gone.  By last Monday's close, the S&P 500 had dropped 3% in five days, a decline that was erased as stocks had again touched all-time highs by Friday¹. Market pullbacks have been infrequent and short-lived of late as strong economic growth, positive investor sentiment, and extreme amounts of Fed liquidity have combined to produce elevated gains with limited drawdowns along the way¹.

To us, Monday's drop does not qualify as a market pullback, but it did serve as a reminder of what volatility can feel like. Having not experienced a material dip in the market in quite a while, we think this is a good time to consider the following perspectives on pullback

1. Conditions ahead contain correction catalysts.

• Rising uncertainties related to the ongoing pandemic, a high bar for growth expectations, and our expectation for an upcoming shift in Fed stimulus raise the odds that a more noticeable stock-market pullback will emerge this year. We don't endeavor to predict its precise arrival, but instead, we think recognizing the potential catalysts can be useful in setting realistic expectations for market volatility, which can better prepare and position investors to react (but not overreact) to larger market swings.
• The increased spread of the delta variant captured the spotlight last week, but we suspect inflation and the implications for Fed policy will take center stage over the balance of the year. We'd attribute the lack of any recent meaningful market corrections in large part to the perceived safety net of extraordinary Fed stimulus that has been in place over the past 13 months. With the Fed likely to soon begin discussing plans for tapering its bond purchases, we think stock-market dips could have slightly more teeth ahead. That said, the real bite will come when Fed policy moves from loose to tight amid sustained rate hikes, the first of which we doubt will come before 2023. 
• Increased worries that the economy has passed its peak are also likely to contribute to bouts of market anxiety. We expect the expansion to be sustained for some time to come, but 2021's expected GDP growth of nearly 7% is likely to be the strongest year in this expansion, with the pace of growth moderating as the economy matures¹. Looking back at the last three expansions, the year of peak growth had an average stock-market return of 11%. The following year saw an average market gain of 5%, with an average of three 5% pullbacks along the way¹. 

Markets have been positive, but more volatile, as the economy passes peak growth.

^{Source: Bloomberg, S&P 500 index performance. Past performance is not a guarantee of future returns.}

This chart highlights the performance of the market in the year of and year after peak GDP growth.

• Market breadth has deteriorated recently, with gains being more concentrated among a smaller number of stocks, as outperformance of the mega-cap tech names (i.e., Microsoft, Google, Amazon, Facebook) has lifted the overall S&P 500 Index¹. To us, this does not signal a breakdown in the broader bull market, but it has been a signal of potential temporary volatility ahead. Looking further out, we expect this measure to improve as cyclical investments (value, small-caps) benefit from renewed optimism around the health of the economic recovery. 

Declining market breadth, driven by gains in a more concentrated number of stocks, often accompanies temporary bouts of volatility.

^{Source: Bloomberg, Edward Jones. Past performance is not a guarantee of future returns.}

This chart shows the relative performance of equal weight and market weight of the S&P 500 as a proxy for the breadth of market gains.

2. Even good markets have bad stretches.

• No bull market is completely devoid of setbacks. Even the second-longest bull market on record (2009-2020) had its share of blemishes. During that period, there were six 10% corrections driven by a variety of factors, including growth scares, trade wars, oil prices and shifts in Fed policy¹.
• The average decline in the corrections mentioned above was 15%, lasting an average of 46 days¹. Patience and discipline were rewarded, however, with an average return of 18.3% over the following six months.
• Last week's sizable swings in interest rates are a reminder that volatility is not reserved just for stocks. Fortunately, bonds are typically on the other end of that see-saw, offering protection for diversified portfolios. During the stock-market corrections above, bonds delivered an average return of 2.9%¹.  

The Prior Bull Market Experienced Several Corrections Amid its Run

^{Source: Bloomberg, S&P 500 Index. Past performance is not a guarantee of future returns.}

This chart shows the trajectory of the S&P 500 through the years since 2009.

3. Check the foundation, not the paint.

• Market declines often emerge without warning. We think it's less about timing the gyrations and more about understanding what lies beneath the surface to support prudent long-term decisions. Put another way, chipped paint or loose shingles may taint the view of a passer-by, but lasting strength of a house is best determined by its foundation.
• The proverbial bones of this market remain healthy, in our view.
  1. The Fed is still accommodative – Despite the likelihood that the Fed will begin winding down its bond-buying stimulus in the not-too-distant future, Fed policy will remain historically positive for an extended period.
  2. Economy still poised to grow at an above-average clip – GDP growth, though moderating from the best level in eight decades – should continue at an above-trend pace through next year.  
  3. Corporate profits are rising – Earnings growth is a powerful driver of long-term market performance. Expectations for double-digit earnings growth this year and next should, in our view, keep a wind at the market's back.
• We're not complaining about the market's lack of volatility this year, but we're also careful to guard against complacency. While we think the probability of a pullback has risen, we believe favorable fundamental conditions mean a pullback or correction can be treated as a buying opportunity.  

Craig Fehr, CFA
Investment Strategist

^{Source: 1. Bloomberg, past returns are not a guarantee of future results.}

Weekly market stats

^{Source: Factset, 7/23/2021. Bonds represented by the iShares Core U.S. Aggregate Bond ETF. Past performance does not guarantee future results. * Source: Morningstar, 7/26/2021.}

The Week Ahead

Important economic data being released this week include Pending Home Sales, Personal Income, and Personal Consumption.