Below is an excerpt containing this quarter's market commentary. To download a copy of our full quarterly newsletter, click the Download Article link.

“When I look back on all these worries,I remember the story of the old man who said on his deathbed that he had had a lot of trouble in his life, most of which had never happened.” ~ Winston Churchill

It is often said the market climbs a wall of worry, and it’s true. Though it can seem confounding at times, the market has an uncanny ability to shrug off concerns and keep churning upward. Think back to exactly two years ago. What was concerning the financial press back then? It was pre-COVID times, just before the presidential election. Surely, much of the worry centered around political risks. But now, none of that really seems to matter, and markets are much higher than they were – despite a pandemic happening along the way. What if you had stayed out of the market based on worries none of us can even remember? You’d almost certainly be less well off.

Here’s the thing. Investors always have something to worry about. That’s what investors do, professional investors in particular. Investment managers get paid to think about all the things that could possibly go wrong, because risk management is synonymous with investment management. Worry is a constant in financial markets, a helpful point to remember. There is always something to worry about, but that doesn’t mean you should worry about it. Much of it is noise, but some of it isn’t. The specifics might change from day-to-day and week-to-week, but barring truly concerning (and rare) events like a pandemic or a financial crisis, the general tenor of worrisome news is always at about the same level – just enough to make you second guess.

In aggregate, the market knows this, and that is what enables it to climb a wall of worry. Over the past few quarters, there’s been a never-ending stream of concerning news. COVID refuses to abate; inflation has been elevated; bond markets have been volatile as rates have been rising; the Federal Reserve might start tapering asset purchases; supply bottlenecks have led to trade imbalances from lumber to automobiles; people are choosing to stay home rather than return to work; U.S.-China tensions have been high; investment taxes might be increasing, etc. The list goes on and on. Nevertheless, the S&P 500 Index is up over 19% since the start of the year, including dividends. Even during the third quarter, which included a rather depressing September, the S&P 500 eked out a meager (but positive) 0.05% total return. One week into October, things are already better than they were at the end of the quarter.

Clearly, markets can and will lose money at times, and one can never know in advance exactly which bit of news will be the driving force behind a meaningful, sustained decline in prices. But most investors have a safeguard in place against severe market events – asset allocation. A properly diversified and allocated investment portfolio should be able to weather even difficult financial storms, keeping a core amount of wealth intact so that an investor can still achieve his or her financial goals. It is better to focus on, and have faith in, one’s asset allocation than it is to spend too much time worrying about day-to-day concerns in the marketplace. Of course, our job is to monitor the day-to-day, and a few things have our attention. For one, after years of double-digit returns, domestic equity valuations remain elevated. The price-to-earnings (P/E) ratio on the S&P 500 Index is 26.5, meaningfully higher than its long-term average of roughly 16. In finance, things have a tendency to mean revert. Getting back to the mean would likely require one of the following two scenarios:

1) Stock prices could drop in the short term. A decline of 25% would realign the S&P 500 Index with a more historically appropriate valuation, accounting for expected earnings growth over the next year.

2) Stock prices could stagnate in the short-to-intermediate term, until such time that earnings have caught up with prices. In this scenario, investors could see successive years of modestly negative and positive returns that average out to lower gains than might be historically appropriate. Corporate earnings would need to remain robust in aggregate, so they could effectively “grow into” today’s high valuations.

Both scenarios come with their pros and cons. Certainly, a 25% correction would be painful in the near term. However, appropriately diversified investors would be given an opportunity to rebalance into lower priced equities, which would benefit them in the long run. The second scenario, by contrast, would result in less overall volatility, but the downside would be a period of malaise where portfolios struggle to earn what they have historically. In such a scenario, bargains would be less obvious, and this would leave less room for the types of opportunistic purchases that can have a significant impact on long-term wealth creation.

Importantly, these scenarios assume a reversion to the mean, which might not happen. A third scenario would be that valuations remain elevated for the foreseeable future driven by historically low interest rates, continued fiscal spending, pent up demand, and sizeable investor cash reserves sitting on the sidelines.

Much ink has been spilled by the financial press writing about inflation. To be sure, prices are higher now (and in some categories markedly so) than they were at the start of the year. We have concern that the Federal Reserve will not be able to time its tightening initiatives as well as it might hope, and inflation could run higher for longer. A worst case scenario of sorts, economically, would be one in which inflation runs hot while economic growth slows or stagnates – a situation known as stagflation. We are seeing enough indicators, between higher prices, persistent supply chain disruptions, and changes in worker behaviors, such that we are not writing off this possibility.

The biggest challenge in navigating today’s equity market, perhaps, is fixed income markets. With interest rates near all-time lows and with credit spreads narrow, investors have relatively few tools to earn money in fixed income without assuming interest rate risk or credit risk. Although bonds remain a critical component of most asset allocations, we expect fixed income to be a relative drag on performance in coming years. For this reason, one cannot simply reduce equity exposure in favor of bonds and expect that decision to yield fruit. As such, middling stock market returns would be welcome compared to bonds that are flat to negative, which provides support for maintaining stock allocations even in the face of high valuations.

In his 1965 novel, Dune, Frank Herbert writes, “I must not fear. Fear is the mind-killer.” Although we’ve outlined a number of less-than-optimistic aspects to our outlook, we do not fear what the future might bring. Fear and worry are not an investment strategy, but fear and worry can lead to poor investment decisions. Whatever comes, there will be ways to respond and to benefit. Volatility and opportunity go hand-in-hand.

To close, here are two exercises to consider, particularly when you’re feeling overwhelmed by worrisome financial news. First, think back to two years ago and how much your portfolio was worth. Chances are, it was lower than it is today. If we were to get a market correction, your portfolio might look about like it did two years ago. Back then, were you financially secure with enough money to meet your goals? Probably. This type of exercise can help to provide context and comfort for any market pullback.

Second, think two years into the future. Your portfolio might not be higher then, but it might. Investments do tend to grow over time, after all. In that future, will you remember today's worries?

Until next time, please contact us should you have questions. In the coming months, may you enjoy much-deserved holidays with friends and family.