The stock market and economy continue to be red hot. Vaccination rates have climbed north of 50% and appear to be effective against new, more contagious COVID-19 variants.

While stocks may seem expensive, pent-up demand is expected to drive corporate earnings to all-time highs which may justify current prices.

We expect the spike in inflation is a short-term reaction to high demand for certain goods and services. We except inflation to level out in the next year or two.

With the Fed acknowledging it plans to let the economy run hot and keep interest rates low, the real return (returns minus inflation) on the $4.6 trillion in money markets is the lowest in many decades.

The pending demise of the bond market seems exaggerated, though we have made some smart adjustments to our portfolios that we believe will increase bond returns considerably over the next few years.

Astonishing is the only way to describe the recovery in the stock market and economy from a pandemic that changed the world as we know it. As we enter the 3rd quarter, U.S. vaccinations have increased with over 50% of the country having received at least one dose. While new, more contagious variants are spreading, the good news is that the existing vaccines seem effective against them as well.

Equity markets have rallied and home prices have surged, with household net worth rising 17% since the end of 2019. Fiscal stimulus geared towards low and middle-income households has put cash in the hands of those consumers most likely to spend it. Industries most adversely hit by the pandemic such as energy, financials and travel have surged and contributed to an amazing pickup in GDP growth that should push the U.S. economy past pre-pandemic output levels before the end of the year.

Can the stock market rally continue?

Yes, it can. Thanks largely to rising consumer spending and trillions in government stimulus, U.S. gross domestic product could rise over 7% for 2021 which would mark the best outcome for the U.S. economy since 1984. Corporate earnings are rocketing higher – the S&P 500 shattered anticipated earnings growth in the first quarter, growing 52% compared to an expected 24%. And we believe the results for the second quarter could be even stronger.

That said, we do want to temper your expectations as the rally in stocks over the last 14 months is unlikely to continue at its current pace. Global equities are expensive from a valuation perspective, though the recent surge in earnings helps to offset that somewhat. Investor sentiment is close to overbought, but not near the dangerous levels of euphoria we saw before the tech bubble burst in 2000.

Dividend paying value stocks, international stocks and small-caps have significantly outpaced growth stocks since November 6, 2020 when Pfizer announced the first successful COVID-19 vaccine. We believe this trend is likely to continue as pent-up demand drives consumer spending on cyclical goods and services that were most affected by the pandemic. With this sudden surge in demand comes another issue to consider, inflation…

What does the increase in inflation mean?

U.S. inflation is making headlines for the first time in decades. While the velocity of the recovery has been remarkable, the sudden increase in demand has triggered supply shortages and bottlenecks. If you’re trying to buy lumber or a used car, you probably feel like inflation is out of control. But our expectation is that the inflation spike is mostly transitory, which is to say it is a temporary reaction to our shut down and subsequent reopening.

For the most part, prices of goods and services were level or down in 2020, so a sharp increase as we return to normal is to be expected. The two-year annualized increase in inflation is roughly 2.5%, which is slightly higher that the Fed’s 2% target. Yet the Fed has acknowledged they plan to let the economy run hot as we recover, which suggests inflation may be sustained at a higher-than-average rate for the foreseeable future. Higher inflation puts pressure on your “real return” which is the amount you earn on an investment minus inflation. This particularly effects short-term investments like cash…

What should I do with my cash?

The personal saving rate soared to 21% in the first quarter resulting in investors having over $4.6 trillion in money market funds, the highest in history. Despite these funds yielding close to zero, fears of an overheated stock market, possible bond market bubble and uncertain future have kept many of you from deploying your cash.

From a financial planning perspective, it is prudent to keep 3-6 months of living expenses in cash. Large expenditures such as tax payments or home purchases that are expected in the next 12 months should also be in cash. Anything you keep in cash beyond that is doing your bank a favor. And with inflation likely to be higher than it has been in some time, your “real return” on cash in the short-to-mid-term is likely negative which hurts your purchasing power in the future.

Generally speaking, excess cash with no specific goals should be deployed in conjunction with your long-term financial plan. At a minimum, it should be invested in income-oriented investments that provide expected returns above inflation. Which leads us to our last question…

Bonds don’t make sense anymore, right?

Not exactly. We believe reports of the bond market’s demise are greatly exaggerated. The answer is some bonds don’t make sense in this environment. As we discussed last quarter, the 40-year secular falling interest rate environment likely came to an end in 2020. But we still expect rates to remain low for some time. In the Fed’s June meeting, policymakers shifted their projections for 2023 from zero to two 25 basis point hikes which is still a modest adjustment that is two years away.

We believe traditional intermediate and long-term “core” bonds don’t make sense in most portfolios these days. The key is to diversify your income portfolio just like you diversify your stocks. Earlier this year we sold your core intermediate bonds in favor of “bond alternatives”, securities with bond-like characteristics that aren’t bonds at all. Rather they are a combination of higher yielding hedged equity with little-to-no market exposure that we believe will increase returns for income investors over the next several years.

Final Thoughts

Concerns about an overheated stock market, inflation and rising rates seem overblown. Yes, the market is somewhat expensive, but earnings growth expectations suggest it may only be slightly overvalued. And that might be justified by historically low interest rates which make stocks more attractive. Yes, we are experiencing a spike in inflation, but it is likely temporary. And the Fed appears in no hurry to implement rate hikes anytime soon.

Rising above the headlines and relying on a well thought out financial plan to dictate your investment behavior is usually the right thing to do. Rest assured we are constantly evaluating the investment landscape and making the adjustments we believe give you the highest probability of meeting your goals.

We hope you enjoy the summer and have plans to travel, dine out and see your loved ones. Now that our office has reopened, we’d love to see you too.