Q3 Market Commentary – October 5, 2021

The third quarter ended on a weak note, with the S&P 500 sliding almost 5% in September.  Although 5% is a relatively small decline, it feels larger because it’s the biggest monthly decline we’ve seen since the sharp market drop of March 2020.  It is also more jarring because it follows seven consecutive months of steady stock market gains.  Still, markets remain up significantly for the year.

September’s decline came despite continued growth in corporate earnings estimates and relatively strong economic data.  But markets are forward looking, and investors have become increasingly anxious about the future – particularly rising interest rates and inflation, whether Congress will pass stimulus and debt ceiling bills, and future COVID-induced economic disruption.  All of this creates uncertainty, and the market hates uncertainty.

First and foremost, the markets are concerned about rising interest rates and high inflation.  It’s not just that higher rates might be expensive for companies.  At its most basic level, a stock’s value is not just how much cash the company can create in the future, but also how much those future earnings are worth in today’s dollars. And when interest rates are higher, future dollars are worth less in today’s dollars. Tech stocks’ sensitivity to interest rates is one reason we’ve recently seen them decline sharply – high growth companies with a lot of their value way out in the future are more sensitive to interest rates.  For example, Facebook fell 10.5% in September and Google lost 9.2%.

Second, the markets have become reliant on stimulus money lately, and toward the end of the quarter it became at least somewhat less likely that an infrastructure bill and the Build Back Better “reconciliation” bill would pass in their currently proposed form.  Less certainty on stimulus, combined with a looming need to pass an increase to the debt ceiling, has meant that Congress has also contributed to making the markets uneasy.

Finally, COVID has created new uncertainties in several ways.  Initially, COVID significantly slowed the economy down.  Now, the new concern will be about getting the economy back up and running.  COVID has created labor shortages and snarled supply chains.  Because recovering from a pandemic is a new challenge in modern times, nobody knows for sure how quickly these issues will be resolved.  Hence, more uncertainty. 


The fundamentals still look good.  Corporate earnings estimates continued their upward momentum this quarter.  Compared to last year’s COVID-suppressed earnings, S&P 500 earnings are now expected to be 43% higher.  Even compared to the pre-pandemic 2019 earnings, 2021’s earnings are still projected to increase by 23%.

Still, market volatility jumped as investors became nervous about the sustainability of the recent rally.  Increased skittishness in the markets this quarter impacted small cap stocks the most, and they trailed large cap stocks.  The Russell 2000 index of small company stocks had total returns of -4.4% in the third quarter, compared to a slightly positive total return of 0.2% for large cap stocks as measured by the Russell 1000.  Smaller company stocks now trail larger company stocks year to date – except small cap value stocks, where the Russell 2000 value still leads other major indexes with a 22.9% return.  Small cap value companies include a large component of small banks, which benefit from rising rates, and some of the popular “meme” stocks like AMC Entertainment, which have done well this year.

International stock returns slightly trailed US stock returns for the third quarter, but emerging market stocks, in particular, did very poorly.  The MSCI Emerging Markets Index declined more than 8%.  China, the largest component of the Emerging Markets Index, dragged the index down, with a -18% return.  Chinese stocks declined mostly due to investor’s fears about growing regulatory actions by Chinese authorities, and concerns about a large real estate firm’s collapse.  Of course, the Chinese stock market is a very volatile one, and an 18% decline is a fairly common occurrence.  Expect more ups and downs ahead for China.


Interest rate increases had paused in the second quarter initially but resumed in September as the Fed indicated it would be scaling back its stimulus.  

The 10-year Treasury rate ended the quarter at 1.52% – not all that much higher than the 1.45% at the end of the second quarter, but the market seems more concerned that this time the upward trend might last.  The Federal Reserve said it planned to start reversing its pandemic stimulus efforts as soon as November and is considering raising short term interest rates next year, given rising concerns about increasing inflation data.

Bond returns were largely flat this quarter, with the exceptions being positive returns in inflation-protected bonds (up 1.8% in the Bloomberg TIPS Index) and high yield bonds (up 0.9% as measured by the S&P US High Yield Corporate Bond Index).


The price of oil initially fell this quarter, but then continued its rise from the extreme lows of 2020.  A barrel of oil (WTI) rose from $73 to $75 this quarter, hitting a seven-year high.  The price of gold fell by 1.2% in the quarter, as interest rates rose and the dollar strengthened.  Gold often tends to move in the opposite direction of the US Dollar.

Looking Ahead

Uncertainty in the markets has been driving some recent volatility.  Still, analysts increased already high earnings estimates for the S&P 500 companies for the third quarter, the unemployment rate continues to decline, and the overall economy, as measured by the Gross Domestic Product, is already back above the pre-pandemic level.  If the uncertainties mentioned in this quarter’s introduction settle down (interest rates, legislation, and COVID disruption), markets should begin to recover their confidence.   

It’s important not to fall into the trap of trying to time the markets.  Just because the markets had been hitting new highs until recently, it doesn’t mean they were necessarily “due” for a correction, with September marking the start of a prolonged downturn.  In fact, recent research by Dimensional Fund Advisors showed that after a new market high, markets returned on average 10.5% annually over the next three years, while after a 20% or greater market decline, the markets returned 9.9% annually in the subsequent three-year period. In the long run, regardless of recent performance, it’s more likely than not that markets will have positive returns.