2021 was supposed to be the year of eradicating COVID-19, with three effective vaccines working their way through various inoculation centers. Major stock market indices rose during the second half of last year in hopes our economy would finally re-open, and businesses would be back to some form of normality in 2021.
After all, the number of infections and deaths has declined substantially since the middle of January. With the vaccines in full force, you would have thought our stock market would be responding more forcefully to the upside. Equity markets started the month of February on a firm footing with a 6% gain in the S&P 500 over the first few weeks. The tech-heavy NASDAQ saw similar increases in early February. Unfortunately, the indices saw gains evaporate toward month-end as a result of higher volatility.
According to the table below, since early February, the technology-heavy NASDAQ saw the most significant decline from its 52-week high. The technology sector, which makes up a large percentage of the index, experienced significant downside volatility in early March. This sector represents over 30% of most major market indices, so when it experiences declines, entire markets feel it. The NASDAQ recently suffered a market correction, defined as a 10% decline, but then quickly recovered some of those declines.
There can be many reasons why markets experience a rise in volatility or declines, but here are a few recent ones to ponder:
Rising Interest Rates & Inflation Fears
A rise in long-term Treasury Bond yields can signal more robust economic growth or fears of higher inflation. The 10-Year Treasury Bond yield has risen nearly .50% to almost 1.60% since January 1. While the 1.60% yield is trivial by historical standards, the increase in such a short time is significant. Inflation fears are starting to filter through markets as rates rise, but those fears may be unjustified. The Federal Reserve already stated it welcomes higher inflation, but markets fear rates might be rising too quickly, and the Fed may have to amend its monetary policy approach.
The recent passing of another trillion-dollar stimulus bill only adds to inflation fears. It is the “too many dollars chasing not enough goods” argument. With all of this money flowing into the economy, will it result in higher costs on goods and services?
Equity performance and bond yields generally move in opposite directions. As yields rise (bondholders selling), investors often shift that money into equities. Yet we saw some of the best-performing stocks over the last year sell-off with increasing yields. Investors value stocks based upon future cash flows, and when longer-term rates start to climb, these stock market valuations can become more extreme.
Keep in mind the technology sector is an area with higher valuations, so it is more vulnerable than other sectors to rising interest rates. Therefore, the pricier the stock, the more vulnerable it can be to increasing interest rates. That is the theory. The practice is more complicated. The market is more concerned about the Federal Reserve having to fight out-of-control inflation by raising short-term interest rates.
Rotation Out of “Stay at Home” and into “Re-opening” Sectors
The stock market can move in mysterious ways sometimes, and this recent period shows just how much. As our economy gets stronger, investors, especially institutional investors like pension funds, try to anticipate which sectors will perform well in a normally functioning economy. We are a ways away from a normally functioning economy, but the “smart money investor” looks to the future and sees areas that benefit from rising rates and an economic turnaround.
The chart below highlights the recent challenges faced by the the technology sector and the outperformance in the energy and financials sectors.
S&P 500 Sector Performance thru 3/5/2021
These cycles happen after a long run of outperformance, which happened in the technology sector as companies like Netflix and Zoom rose substantially during the pandemic. I’m not sure if the above chart will look this way by year-end, but it shows investors are willing to look beyond technology for better performance. It is healthy over the long term to see more sectors benefit as the country moves forward post-COVID-19.
Fears of higher interest rates and periodic market pullbacks and corrections are a normal functioning part of markets. They happen when we least expect them, especially during a year where we are making headway with COVID-19 vaccines and improving economic data.
It is crucial to keep the long term in mind when assessing market declines and volatility. While the recent period has been volatile and markets declined, the market returns off the 52-week lows continue to look very strong; some of the strongest on record.
In periods like these—when the market is fearful in the near-term, but economic trends look positive—it makes sense to remain focused on your goals and objectives and make sure you have an appropriate investment strategy to meet those goals.