Driving Through The Rear-View Mirror Could Be Dangerous

October 11, 2021 by Martin L. Yokosawa

I hope everyone enjoyed the summer months. If one took the summer months off and returned
from a long boat ride from China, you would think the quarter was ho-hum since the market levels
were essentially unchanged. That was not the case for asset managers navigating the markets on a
daily basis. Some of the issues at the forefront of investors’ minds include interest rates, inflation,
supply chain disruptions, labor shortages, energy shortages, slowing China and the Evergrande default, and Fed tightening. I’ll get to these issues in a moment.

During the third quarter of 2021, the S&P 500 Index gained 0.2%, the NASDAQ Index was down
0.4%, the Russell 2000 Growth Index lost 5.7%, and the iShares Barclays 7-10 yr. Treasury Bond
ETF (IEF) lost 0.2%. ¹

¹These returns are priced based and exclusive of dividend reinvestment.

Despite the uneventful returns there were interesting developments after the recent S&P 500 high
in early September. As a reminder, the S&P 500 is a stock market index tracking the performance
of 500 large companies listed on stock exchanges in the United States. What is overlooked by
many investors is that five companies, or 1% of the holdings, represent 22% of the index and have
been the market drivers for some time. They are Apple, Microsoft, Amazon, Alphabet (Google),
and Facebook.

The first interesting point is that since the market high through the end of the quarter, the S&P 500
is down 5.2% while Apple lost 10.0%, Microsoft 7.8%, Amazon 12.9%, Google 9.2%, and
Facebook 11.7%, much more than the index.

The second interesting point is that these companies were benefactors of the first COVID
shutdown but are seemingly not benefiting from the Delta variant outbreak. These points tell me
the market is getting tired and there is a rotation out of the past leaders.

If I’m correct about a rotation and the market begins to earnestly adjust for the hurdles facing the
economy, I expect to see higher volatility and a near-term correction in the markets. I have raised
cash levels in anticipation of such an event. No one enjoys a correction or knows exactly when it
will occur, but it is a part of investing, and a reset is a good reality check for investors.

Here is how I see things today.

Positives:

1. The Federal Reserve continues to promote an accommodative policy
2. The Delta variant seems to be winding down
3. There is pent up consumer demand for future purchases due to supply chain shortages
4. Pending bi-partisan infrastructure bill
   

Negatives:

1. Supply chain disruptions
2. Global Energy shortages
3. Labor shortages
4. Inflation
5. China problems

Currently, the negatives except inflation appear to be short-term and may be a catalyst for higher
future economic activity. That is the reason I believe a stock market correction may manifest itself
in the next several months.

In my opinion, the largest variable is how the market will handle the eventual Federal Reserve
tightening. In any event, tightening will cause interest rates to go up. The current Fed seems to
have learned that being transparent and methodical about their changes is a good way to not overly
upset markets.

If interest rates don’t rise too much in speed and magnitude, I believe that smaller nimble
companies will have an edge on larger companies in adjusting their business models. This in turn
should produce attractive earnings growth and lead investors to this area. Below represents how
the small-cap Russell 2000 index performed better than the large-cap Russell 1000 index from
9/30/01 to 9/30/21 when the 10-year Treasury yield rose.

This is my area of expertise, but I still will wait for company sales and earnings growth confirmation before evaluating an opportunity. Investing simply on intuition or a general idea is guessing and not productive. Due to the global energy shortages and underperformance of the energy sector, my expectation is that many names may surface in that area. Due to the labor shortages, I would expect staffing companies should benefit as the economy reopens once again. If persistent inflation exists, commodity-related opportunities should do well and surface. As always, I look forward to the upcoming earnings reporting season to seek out new opportunities.

Other mentions and news I’m watching for:

1. If Congress does not do their job and a technical US debt default occurs, a ratings downgrade would likely fall causing a severe negative market reaction.
2. The resulting fallout of heightened crypto currency scrutiny:
   I. Amid repeated warnings from SEC Chief of Commission Gary Gensler, the SEC aims to crack down on the use of cryptocurrencies.
   II. The Department of Justice has hatched a new unit dedicated to its policing.
   III. Congress is pointing towards bringing crypto-currencies under full oversight and control
3. The development of a digital Chinese Yuan in an effort to debase the US Dollar as the reserve currency. I think this is an unlikely event in the near future as:
   I. Chinese government’s lack of transparency
   II. The volatility of crypto currencies is extreme and the recent Tether/Stablecoin controversy, making any digital currency far less attractive.
   III. The US Dollar comprises about 59% of central bank reserves and is involved in about 90% of all international trade transactions.
   IV. Global debt is mostly dollar denominated

It should be an interesting fourth quarter.

To our existing clients, I extend my sincere thanks for your business. You have our continued commitment to your success. To prospective clients, I invite you to come and grow with us.

^{Torii® Asset Management, Inc. Landolt Securities, Inc.
9S040 Stearman Drive, Naperville, IL. 60564
Copyright Martin L. Yokosawa. All Rights Reserved
Securities processed by and investment advice provided through Landolt Securities, Inc. Member: FINRA/SIPC
Torii Asset Management, Inc. and Landolt Securities, Inc. are not affiliated co}