“Good investors gather information, put that information into current and historical context, then make sound decisions.”
Equity markets experienced their first divergence of the year 2021 in March. A divergence is defined as a ‘parting of the ways’ between different market indexes or sectors, such as large cap from small cap, or S&P 500 Index from the NASDAQ Composite Index. For the most part all of them had been rowing together since last November. So much in fact that investing in equities had started to look ‘too easy,’ which means that the lazy ones were about to get rocked out of the boat. It started with some classic short squeeze plays on thinly traded stocks. These always look easy from a distance, except that you can get caught on the wrong side of the play and lose WAY more than you invested to start with. Please excuse the technical terminology and remember the ‘too easy’ part. Because it never is.
The second part of the March divergence occurred when the tech-heavy NASDAQ Composite Index kept going down, while the more diversified large cap S&P 500 Index turned back up, led by bank stocks. This was disconcerting because ‘everyone knows’ that you make big money in tech and slow money in banks. What could be wrong? Nothing. Remember that institutional investors are the ones moving stock and bond indexes around, not ‘Robinhooders.’ Institutional investors prefer to re-balance portfolios periodically because they invest for the long haul, not the sprint to the corner store. This means selling securities that have become significantly overpriced and buying those that have been quietly chugging along. And that is what they did in March. Was the sky falling for tech stocks? Nope. They are still very much in the mix, which they have been proving the past couple of weeks. As for the numbers, while the NASDAQ Composite Index declined -14.6% before bouncing, the S&P 500 fell by -5.9% before bouncing. The S&P Bank Index rose +12.34%
International equities diverged in March as well. The MSCI EAFE Index and the MSCI Europe Index had both been climbing slowly in 2021, while the more aggressive MSCI Emerging Markets Index has risen twice as much. During the March correction, however, the more diversified MSCI EAFE Index and MSCI Europe Index declined by -5.0% and -4.19%, respectively, less than half of the -10.7% drop of the MSCI Emerging Markets Index. Does this mean that we should run from Emerging Markets? Absolutely not. Emerging markets had a very strong rally in February and had plenty of room to correct, just as the U.S. technology stocks had room. Minor divergences serve to equalize over-bought and over-sold discrepancies. Major divergences are another matter altogether, as they can continue for months or even years.
The threat of a major divergence has had a negative effect on bond markets in 2021, especially the government bond markets. Major divergences are associated with long-term trends. A long-term threat to any bond market is inflation. A long-term threat to specific government bond markets is the strength of the underlying government’s currency relative to other currencies. When inflation is rising and the currency is declining, it is a double shot of trouble for that country’s government bonds. The current yields on U.S. Treasury Bonds are near record lows. The current inflation rate estimates in the U.S. are rising. The U.S. Dollar is more than 10% lower than one year ago. Even institutional investors have been put on notice. Granted, there are many sectors to the bond markets, and there are many solutions for income investors. But it’s not easy either.
Equity markets appear to have the smoother road ahead for 2021. While we have already experienced two minor corrections this year, the long-term trends are intact. The fundamental conditions are very encouraging. Corporate earnings are projected to be at or near record levels. The low interest rate environment is a significant positive for the consumer, and consumer spending is 2/3 of the U.S. economy. The U.S. is reopening after an unprecedented COVID year. The major threat is a resurgence, which should be manageable if we follow the rules and the reopening is slow and easy.