Watching financial markets recently, you might be reminded of when you were a child watching a pot of water boil at your grandma’s house. “A watched pot never boils,” your grandma may have told you. If you were a stubborn child, you would know that the water eventually booted, but it seemed to take forever.
With high valuations, peak economic and earnings growth, fading stimulus, supply disruptions and looming Delta variant fears, many investors watch for a correction, defined as a 10% fall in stocks. Corrections are normal—they happen roughly every eight months on average, going back to 1928. Legendary investor Peter Lynch once said, “More people lost money waiting for corrections and anticipating corrections than in the actual correction.” Sticking to the long-term risk and return objectives is still prudent.
The economy appears to be slowing from peak growth in the second quarter, and the size of the overall economy has surpassed pre-pandemic levels. With the headwinds mentioned above, growth will slow from currently unsustainable levels. The Fed is looking at tapering its bond purchases and eventually raising rates. Inflation is currently high but expected to moderate. The question is, at what level will inflation stabilize? We expect it will likely settle somewhere above pre-pandemic levels but lower than where it is today.
Before the Fed starts to decrease stimulus, officials may want to make sure the economy is on sound footing. The problem is that short-term inflation ticked up again due to temporary supply-side constraints caused by the Delta variant. Fed prognosticators can’t get an accurate temperature reading on inflation and don’t want to overreact, as tightening financial conditions too fast may cause a slowdown, potentially hurting the economy and labor markets.
In stocks, investors are looking at the same data and gauging what the Fed will do. See our Fed Monitor as we try to gauge the Fed too. Stocks remain expensive relative to their projected future earnings. Additionally, the S&P 500’s most significant drawdown in 2021 was only 4.23% (as of this writing), which occurred in March. Meanwhile, volatility remains relatively low in the face of all these risks. So naturally, many investors are waiting for the pot to boil (a stock market correction), but of course, that takes time.
Bond investors are probably even more worried about what the Fed will do but seem to believe that tapering and rate increases will come in a slow and dovish fashion. Inflation is retreating, which gives the Fed some room to take a wait-and-see approach to raise rates.
We reiterate our recommendation to diversify across asset classes, sectors and countries while adhering to the long-term risk and return objectives. We remain cautiously optimistic, but risks are increasing, and therefore we are more balanced in our outlook.
Cetera Investment Management LLC created this report. Cetera Investment Management LLC is an SEC-registered investment adviser owned by Cetera Financial Group®. Cetera Investment Management provides market perspectives, portfolio guidance, model management, and other investment advice to affiliated broker-dealers, dually registered broker-dealers, and registered investment advisers.