Stocks fell on Friday, capping off one of the weakest weeks for equities in a couple of months.
This is earnings season. For the past two weeks, earnings reports for more than half the S&P 500 have been released. Results have been excellent. Actually, they have been more than excellent. Companies regularly have beaten expectations. With revenues surging, margins have benefited as sales rose more than expenses. Estimates for the rest of 2021 and 2022 have been increased amongst almost all of Corporate America.
Yet stocks overall have retreated. It hasn’t been a decline that is very scary. But why would stocks drop when corporations are in the middle of such a sweet spot? You can’t blame interest rates. Over the past two weeks, they have risen a touch, but nothing near enough to offset the huge earnings being reported. You can’t blame the Fed either. At last week’s FOMC meeting, the Fed said it isn’t nearly ready to start reducing its pace of bond purchases, let alone start to raise short-term interest rates.
No, it all comes down to the old story of reality versus expectations. What the market told us last week is that while analyst estimates for future earnings were a bit too low (or, in some cases, more than a bit), investors had already discounted what analysts had not. Better than forecasted earnings were the common expectation. For sure, there were a few companies that beat expectations by so much that their share prices did rise. But they were the exception. Take Apple#, the biggest company in the S&P 500. It handily exceeded forecasts and its stock fell in the aftermath. It didn’t fall by a lot. In fact, it only retreated to levels of a couple of days or weeks earlier.
That of course raises a big question. If stocks of companies with superlative results aren’t going up on better than expected news, what is going to drive prices higher? That’s a great question! Obviously, with vaccinations rising and Covid-19 case counts falling, there are lots of reason for optimism. Restaurants are filling up, indoors and outdoors. Airline reservations are surging. Last year, 37% of Americans took a vacation away from home. That is likely to double this year. But don’t we already know that? Stocks look ahead. Shouldn’t they be discounting what is so logical?
Of course, the answer is yes. But that doesn’t mean stocks are in for a sharp correction. Stocks don’t usually tumble amid surging earnings, whether expected or not. But today’s S&P multiple on 12-month forward earnings is still about 8% higher than it was a year ago. Even if I allow that earnings estimates of analysts are still too low, the multiple is still not coming down.
But the big surge in economic activity won’t last forever. The economy will still grow, and it will grow at rates higher than normal, but the pace of growth is gradually going to subside. Year-over-year, earnings growth will peak in the June quarter. If you look back twelve months, March, April and May were the peak quarantine months. We see what’s happening today. So anyone can figure out that year-over-year comparisons this quarter will be off the charts.
But more astute investors won’t look year over year, they will look at sequential changes. Even using sequential numbers, the economy will be more open in the June quarter than it was in the March quarter. The September quarter will show further gains. But the rate of improvement, the second derivative, will start to slow.
The economic data last week was telling. GDP in Q1 rose by more than 6%. But if I back out inventory declines, the gain in final sales was almost 10%. Money supply is growing at a rate of almost 25%. Savings have been growing close to 20%. Between people returning to work and a series of Government relief checks, most Americans have been taking in more than they can spend, at least up to now. Looking ahead, there will be some catch up. Cabin fever will send us out onto the road. We will buy clothes other than pajamas and leisure apparel. But that post-Covid splurge won’t go on forever.
We also learned last week that all the renewed demand is creating shortages and higher prices. Existing home sales are up 17%. Regular gasoline is now about $3. Airline tickets are repriced upwards daily. Companies are paying more for workers and still having trouble finding them. Meanwhile, chip shortages are hurting some sales, notably in the auto industry. Many car dealers literally have no new cars to sell.
Utopia may be here but it won’t be here forever. Maybe if President Biden is successful in getting $4+ trillion in new spending bills passed by Congress, the party might last longer. But I expect getting to the finish line won’t be simple.
There is an old saw on Wall Street to sell in May and go away. Seasonal patterns suggest volatile sideways movement from May through October. The last 2-3 years have been quite a ride. Predicting an end is perilous if you are wrong. I am not predicting anything with any conviction. But when stocks stop going up on sensational news, there is a message. To me that message is that an awful lot of good news has been priced in. Since we all know that Q2 is going to be even better than Q1, that probably is already priced in as well. The future path of interest rates is concerning. We already see in areas like housing what happens when supply can’t keep up with demand. If our nation hires 1 million additional workers every month, how long will it take for wage pressures to rise?
Over the next several months there will be lots of debate over the President’s plans. How they work out is questionable. Fed Chair Jerome Powell said most current inflationary pressures are transitory. Will that be a general belief 3 months from now?
I have said all along that early 2021 would be better for stocks than late 2021. I still believe that. It doesn’t mean a correction is forthcoming, but it does mean concern will rise as the rate of improvement slows.
I am not advocating selling anything per se. I am advocating paying attention to your asset allocation and not letting it drift too far without making adjustments. That is hard to say when cash and bond returns are negative in real terms. But it does mean don’t chase. Rather, pick buy points and wait for some correction to buy or add to positions. It also means that some profit taking is in order, particularly in the speculative fringes of the market where 20-30% corrections have already taken place. The two greatest investment attributes are patience and discipline. Use them.
Today, both Christina Hendricks and Willie Geist are 46. Francesco Castelluccio turns 87. You might recognize his performing name better, Frankie Valli.
James M. Meyer, CFA 610-260-2220