Profitable summer … frenetic fall?

Dave Donabedian, CFA

September 15, 2021

The stock market has experienced a remarkable run despite pockets of speculation around the fringes. What might change?

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A quick look back

There aren’t enough adjectives to describe the remarkable run the stock market has had, so we will stick with some statistics for the S&P 500, including:

  • 12 new all-time highs reached in August alone
  • Seven consecutive months of gains
  • A 107% total return since the panic-stricken COVID-19 lows of March 20201

In this market resurgence, there have been pockets of speculation around the fringes. Cryptocurrencies, meme stocks and special purpose acquisition companies stand out. By and large, however, stocks have advanced because the fundamentals have been unambiguously positive. That may seem like an odd statement given the ongoing pandemic. But the policy responses to COVID-19 are what propelled equity prices so much higher.

Those responses took three forms: monetary policy, fiscal policy, and accelerated vaccine development and distribution. The Federal Reserve’s (Fed’s) extraordinary actions last year calmed panicked sentiment, flooded markets with liquidity, and drove yields on bonds and cash so low that it made investing in riskier assets the only game in town for many investors.

Chart: Flooding the zone with liquidity - Federal Reserve balance sheet

Fiscal policy provided trillions of dollars directly to households and businesses to keep them afloat in a dysfunctional economy and helped sow the seeds of recovery. The successful development of COVID-19 vaccines in record time boosted confidence that the pandemic could be mitigated in a way that would allow for daily economic activity to return to some semblance of normalcy.

Tougher from here

Our outlook for the rest of this year and into 2022 is balanced. We sense that the bull market has staying power, tempered by the belief that we will see lower returns and more volatility compared with recent months.

The government’s second-quarter gross domestic product (GDP) report showed that the overall level of economic activity reached an all-time high, recovering what was lost during last year’s quick but brutal COVID-19 recession. Thus, we are early in an economic expansion—a highly unusual time for a bear market in stocks to occur. Corporate profits also look to be on an upward trajectory, while liquidity and credit conditions remain highly favorable.

While we don’t think the bull market is at serious risk, multiple factors lead us to believe that the “one-way” market environment is drawing to a close. That “one way” has been higher, as evidenced by the statistics listed earlier, as well as the S&P 500 going 214 days without even a 5% pullback. There are only six longer streaks in the history of the modern S&P 500 dating back to 1957.2 Despite all sorts of drama in the real world, equity markets have been placid by comparison.

This may well change in coming weeks, as a variety of uncertainties come to a head:

  • The economic impact of a fourth wave of COVID-19
  • The sustainability of higher inflation readings
  • Timing and scope of the Fed’s policy inflection point
  • The potential for a multitrillion-dollar federal spending package accompanied by major tax increases
  • The need to raise the federal debt ceiling, most likely by the end of October

Growth, inflation and the Fed

There is evidence that the delta wave slowed economic momentum in the third quarter. The spike in consumer spending earlier in the year has rolled over, in part due to the waning of prior stimulus packages. Supply chain disruptions persist, creating a mismatch between what consumers want and what is available for purchase. Until recently, forecasts for real GDP growth in the second half were similar to the first half’s very strong 6.4% annualized rate. Those forecasts are now coming down.

Meanwhile, inflation data remains on the high side. August’s consumer price index (CPI) was 5.3% above a year ago. While Fed Chairman Jerome Powell deemed this significant overshoot of the central bank’s 2% inflation target as a “transitory” adjustment period, the burden of proof is increasingly on the Fed. If there is any relation between the real world and government data, we should see the enormous increase in home prices and rents filter into the CPI in the months ahead. Our expectation is that the inflation data will stay stubbornly high, bringing into question the credibility of the Fed’s transitory scenario. A result of this would likely be a rise in bond yields, with the 10-year Treasury challenging its 1.75% levels reached in March.

An outlook in which growth slows down and inflation revs up poses a challenge for the Fed. We believe the central bank is likely to proceed with reducing their monthly bond purchases before year-end (aka, tapering quantitative easing). While largely anticipated, this is an important inflection point during which the Fed gradually reduces market accommodation.

After going quiet over the summer, fiscal policy is once again a front-burner issue for financial markets. Both houses of Congress approved a budget resolution allocating $1 trillion for infrastructure investment and $3.5 trillion to expand the social safety net. In the days and weeks ahead, we will find out more specifically how the money is to be spent, and the range of tax increases proposed for funding it. Given the political linkage between the two pieces of legislation, it is possible that neither passes, especially given that there appears to be no Republican support for the $3.5 trillion package. Our expectation, however, is that the infrastructure bill will pass at very close to $1 trillion, and that the safety net package will pass at a slimmed down (but still huge) $1.75 trillion or more.

There are undoubtedly industries and companies that will benefit from the legislation, and we are on the lookout for them. But overall market sentiment may be more impacted in the short term by the potential tax increases. One policy analyst believes the tax hikes cumulatively will be “the biggest tax increase package in 50 years.”3 At this point, we expect that several investmentrelated tax rates will rise, including on overall corporate profits, foreign earnings, capital gains and dividends. As legislative details get filled in, you’ll be hearing from CIBC’s Investment and Wealth Strategies teams on the implications from both portfolio and planning perspectives.

Putting it all together

The prior section describes an outlook of marked down growth, higher inflation and bond yields, and a less friendly policy environment. This is why we expect lower returns and more volatility from the stock market for the rest of this year. It’s quite likely that the 5% pullback streak referenced previously will be broken, and a market correction is possible. Historically, declines of 10% or more in the S&P 500 occur more than once a year. Still, we would view any material decline as a setback within a bull market and, therefore a buying opportunity.

Our reasons for believing that this bull market is sustainable come down to earnings and relative valuations. After a huge recovery in profits this year, S&P 500 earnings are expected to grow by another 9% next year.4 This would value the S&P 500 at a 19.7x price-to-earnings multiple on 2022 estimates. While high in absolute terms, it is reasonable in the context of a growing economy and relatively low interest rates. Thus, we expect equity markets to trend higher in the months ahead—but it will be bumpy. The S&P 500 rose 31.5% in 2019, 18.4% last year and 21.6% in the first eight months of this year. Those rates of return are unsustainable, and investors would be wise to have more modest expectations for what the market will provide over the next several months.

Chart: Historically generous returns from the stock market - S&P 500 total rate of return

Dave Donabedian, CFA is chief investment officer of CIBC Private Wealth Management, serving in that capacity since 2009. His responsibilities include chairing the Asset Allocation Committee, as well as providing oversight of internal investment strategies and the external manager selection platform.

1. Bloomberg, August 31, 2021.
2. Bloomberg,, September 9, 2021.
3. Dan Clifton, Strategas Research, September 8, 2021.
4. Yardeni Research, September 8, 2021.