We are now 15 months removed from a Covid-induced pandemic that shut down the world. Looking back to last year, not many, if any, could have expected such a massive rebound in economic conditions, earnings and a global vaccine rollout that put everyone on a path to normalcy so quickly. Halfway through 2021 we have another roaring equity market. So far, the S&P 500, Dow Jones and Nasdaq are up 15.2%, 13.7% and 13.2%, respectively, including dividends. That would be good for a full year, let alone six months. The S&P 500 is already at most economists’ year-end price targets.
Earnings have been the primary driver, albeit they have been goosed by excessive fiscal and monetary stimulus. Whether one agrees with modern monetary theory or not, we’re basically doing it now. After one of the most unusual recessions, consumer balance sheets are actually better today than before lockdowns. Consumer net worth is at record highs. Many companies are out-earning their pre-pandemic records, some by a substantial margin. Great news is all but priced in. Companies’ ability to outpace rosy earnings scenarios, further labor improvement and Federal Reserve actions from here will determine the next 10% move in either direction.
A shift has also occurred over the past two months, with growth stocks resuming a leadership role they held for the past decade. From the onset of vaccine approvals in November thru May, the S&P Value Index jumped 40% while growth stocks were only up 15%. Since then, growth is up 11% (Cathie Wood’s Ark Innovation Fund was up 26%), and value is actually down 3% through the end of June. Leadership has narrowed, pointing to underlying weakness for the average stock, while indices keep making new highs.
Let’s examine the bull/bear debate as we prepare for much deserved summer vacations, gear up for kids going back to school and enter the second half of 2021.
• The Fed is committed to 2%+ inflation. and more importantly, full employment. They will disregard excesses in the market until these two agenda items are firmly in line with their goals. Purchasing $120B in bonds on a monthly basis continues to suppress interest rates, allowing borrowers to take out loans for any project they want. 0% Fed Funds also allows more risk-taking. All of which point to equities remaining an attractive asset class.
• Vaccinations are finally expanding globally. With over 50% of the U.S. vaccinated and several countries above that, reopening plans are working. Excess vaccines in the U.S. are being distributed abroad. This will alleviate many countries’ worst fears of not having enough needles. All signs point to Pfizer, Moderna and J&J’s vaccines being effective against all known variants as well. We are in the final innings and will see another 3B+ global consumers catch up to the U.S. as they hopefully reopen safely.
• Inflation is peaking. With more people going back to work, supply chains being repaired and factories ramping up to full capacity, many prices have already peaked. Lumber is the hallmark input cost for homes and has been cut in half. Most commodities, outside of oil, are down substantially. If inflation is indeed transitory, then interest rates can stay in a lower trading range, keeping P/E’s elevated and loan demand appealing.
• Capital expenditures pulled forward years of investments and should lead to greater productivity. During the shutdown, many companies focused all of their spending on cloud, 5G, online capabilities and replacing humans with software/robots. McDonald’s# still gets your order without a cashier. Target# can get an online purchase to your doorstep in one day. Factories with new sensors can pinpoint future production mishaps without anyone in the building. A lot of capital spending last year will bring increased innovation today, while also yielding higher margins due to lower labor costs and less downtime when most needed.
• Corporate profits are far from peaking. Yes, the growth rate peaked in Q2, but it does not mean an end to expansion. The first few quarters coming out of a recession are always the strongest. So long as interest rates remain tame and international vaccine rollouts proceed, the rest of the world will catch up to the U.S. That will yield solid profits across the board. An old adage that works is that stocks don’t peak until earnings do. We’ve got plenty of room to run in earnings, even if the trajectory isn’t a straight line up anymore.
• Valuations are out of whack. Stocks trade at 20x earnings. Historically, that points to flat returns over the long haul. Real money is made when you buy winners at a discount. When looking at Price/Sales, Price/Book or many other metrics, the only other comparable period is back in 2000. That Y2K bubble did not end well.
• Inflation is here to stay. While the Fed keeps looking at those unemployed or a low workforce participation rate, they are letting inflation run too hot for too long. Eventually, that points to much higher interest rates, which reduces P/E ratios. 10-Year Treasury rates should be a risk-free return + inflation. That points towards at least 3%, while we sit at sub 1.5%. If markets are wrong and inflation lasts longer, interest rates could shoot much higher.
• Covid variants keep popping up while more countries shut down again. This is a serious wild card. The Delta variant is already forcing Sydney, Australia to reimpose lockdown measures. So many businesses had to close forever last year, leading Governments to print money as extreme measures. Can we do this again? How many more businesses will fail, putting millions more back on the unemployment line if shutdowns come back?
• Markets are making new highs, but fewer and fewer stocks are participating. Last year produced a broad-based rally where most stocks ran. Now that everyone knows we’re hitting peak growth, leadership is moving back to FANGMAN and mega-caps. That is not healthy and usually precedes a market correction. If an “average” stock has peaked, the averages aren’t far behind.
• Great news is more than priced in. Economically sensitive areas like housing, commodities and deep cyclicals are down, some substantially so, over the past several weeks. If we are going to keep growing, they should start to act better. This divergence also usually precedes a market correction. Last week I mentioned the Dow Theory sell signal that goes hand-in-hand with this indication.
Much of what will happen over the final half of 2021 will be determined by Fed commentary and reactions to any statistic that changes their aggressive stimulus posture. Recent data points are helping to prove their point on transitory inflation (commodity prices collapsing) and an under-utilized labor force. Just because the growth in inflation is peaking doesn’t mean it is a non-factor. A 2.5% CPI, paired with 4%+ wage inflation, is not something the market wants to see stick around forever. More signs of this leads to tapering and higher interest rates, a terrible scenario for elevated P/E’s. That is not our base case. We continue to believe inflation will be transitory and wage inflation should get back to historic norms once we get past the Fall.
On the jobs front, another critical data point is out this morning with June employment statistics. Consensus views are for continued improvement, possibly an average of 500k jobs per month thru the Fall season. Unemployment benefits will expire in September, even sooner for States that cut them off early. Most schools are set to fully reopen, allowing stay-at-home parents to rejoin the workforce. Vaccinations and low Covid numbers should also ease fears about going back to work. We continue to expect full employment in the not-too-distant future. That is quite positive when combined with low interest rates and trillions of dollars in stimulus circling the economy.
Stock price appreciation from here should be a lot choppier. Outside of Fed taper + inflation concerns, there are proposed tax increases, high valuations and margin pressure stemming from the labor force that will make this more of a grind higher rather than the straight shot we’re becoming accustomed to. We have not seen a 10% correction in 14 months, when one should occur annually. A 5% drawdown, at minimum, should be expected.
Any correction would be welcome news. Markets need a cleansing and a digestive phase. Going straight up creates excesses like we saw earlier in the year with SPAC’s, unprofitable IPO’s, and anything tied to crypto skyrocketing, even a doge coin. As we keep pounding the table, the bull market is not over but it will also not be this easy forever. Building a new shopping list, in case a correction does occur, is prudent. Things may get more difficult from here, but plenty of upside remains over the long haul.
Seinfeld and Curb Your Enthusiasm’s Larry David is 74 today. Actresses Margot Robbie and Lindsay Lohan are 31 and 35, respectively.
Markets are closed on Monday, enjoy the long 4th of July weekend!
James Vogt, 610-260-2214