We have been expecting market volatility to pick up as our economy shifts gears coming out of the pandemic. Stay-at-home stocks were massive winners in 2020, while reopening companies took the baton for the early part of 2021. Now that we’re getting back to some sense of normalcy, it becomes a much more difficult market to predict. Inflation statistics are well above trend, with a new sense that “transitory” means different things to different people. Growth rates have already peaked, but accurately predicting GDP 12 months from now is nearly impossible. Interest rates are going down while economic data is coming in hot, the opposite of what many expected. All of this adds up to an uncertain market.
This week brought significant volatility in just a few trading days. Monday saw a near 1,000- point drop in the Dow Jones Industrial Average. Massive spikes in Delta cases across the globe put recovery momentum to the sidelines with many emerging markets reverting back to shut-down methods. In total, the Index dropped 3.8% from Friday’s high in just two trading sessions. Markets still have not experienced a 5% correction since last year, when history shows that 2-3 corrections occur annually. Not to be outdone, 10-year Treasury yields collapsed as well, touching 1.13%. They reached 1.77% just three months ago.
Fast forward a whopping 4 days and we’re back to being just 0.2% off of new highs in all major indices if market futures hold up. Treasury yields recovered somewhat, bouncing back to 1.25% yesterday. A realization that vaccinations are helping keep hospitalization and death rates low should keep easing fears of this Delta variant. Vaccine supplies have ramped up and we have more than enough in the U.S., to the point that they are being shipped to less fortunate countries. Optimistically, the needles everyone is getting can make new variants feel like a very bad flu but not be a death sentence. This will keep businesses, restaurants, stores and schools open. Sure, some will want to wait it out, but there is enough pent-up demand to support solid growth.
Earnings are also helping this rapid recovery. Second quarter revenue and EPS estimates were raised, substantially so, over the past few months. Reports out this week are besting those projections handily. Nearly 20% of the S&P has reported, with 85% of them besting consensus. This is slightly ahead of the normal ~75% range. Financials are leading the way, coming in 26% ahead of analyst projections. The rest of the market is beating by an average of 11%. Beats have been broad-based with big-cap pharma, wireless providers, banks, semiconductors, insurance and consumer staples mostly exceeding forecasts.
This brings Q2 expectation for 68% EPS growth up to 78%, albeit off a very low base from last year’s shutdowns. Unlike Q1, beats are being rewarded with positive price momentum as well. Next week brings a slew of reports, which is sure to cause more day-to-day volatility. One should expect similar action, but any miss in forecasts will be met with aggressive selling.
As noted in prior letters, this is all positive news. A straight-line advance to the sky is usually met with aggressive selling and a crash. Witness the ~50%+ drops in lumber, Bitcoin, SPACs and even NFT prices. A market that doesn’t self-correct usually sees a great fall.
What doesn’t look promising continues to be market breadth. Although most of the market was positive after Monday’s brief respite, we’re still stuck with very narrow leadership. Major averages are being propped up by mega caps yet again. The soldiers have left the field, leaving the Generals to do all the work.
One way to examine this is an advance/decline tally. This is simply a breadth indicator calculated by taking the difference between the number of advancing and declining issues and adding the result to its previous value. It rises when advances exceed declines and falls when declines exceed advances. A rising trendline equals broad participation and vice versa. Here’s where we stand today:
The S&P 500 (black line) keeps making new highs, while the average stock is dropping (blue line is advance/decline). Shifting gears in an economic cycle from early to mid usually results in a separation of long-term winners and losers. The rising tide will not lift all boats as strong as it did off the bottom. However, a trendline like this doesn’t last forever. Either more stocks start turning higher or we risk the chance of a real correction, not just the minor 4% drop earlier this week. Here’s hoping earnings reports next week keep coming in stronger, allowing more companies to join the party to new highs.
However, the most likely course of action is that interest rates tick higher first. With so many companies in sectors such as financial services, commodities and industrials tied at the hip to inflation and interest rates, it is unlikely they move without action in bond land. After a sizable pullback in just a few months, that’s not a bad bet to make.
Daniel Radcliffe, of Harry Potter fame, is 32 today. Guns N’ Roses guitarist Slash turns 56. Woody Harrelson is 60 and Monica Lewinsky turn 48.
James Vogt, 610-260-2214