Market Update Summer 2021
U.S. equity indexes advanced higher in second quarter. Favorable U.S. news on Corona virus, vaccinations, re-openings, robust economic growth, and record corporate earnings fueled the advance. Stock market is vulnerable to bouts of higher volatility in the coming months which is typically a seasonally weak period.
The S&P 500 is in Bull market pattern with the index’s cumulative advance/decline line showing broad market participation confirming it is uptrend. There are more gains ahead as market breadth at the sector level is far from overbought.
Market trading as if inflation is transitory. TIPS Break even yields are way off their March highs, and economic growth is expected to remain strong but decelerate somewhat in coming quarters. I expect Fed to hike sooner than Fed officials say. The FOMC most likely will announce tapering plans as early at the August Jackson Hole meeting. Futures market pricing in a hike in October 2022 sooner than Fed “Dots”.
History shows that stock returns remain robust in the months leading up to and following the first-rate hike. More specifically, over the past four rate hike cycles the S&P 500 gained 9.5% in the twelve months prior to the first hike, and 26.0% over the subsequent three years. The real damage from higher rates tends to occur later in the cycle when tighter policy inverts the curve.
With the percentage of the U.S. population having been vaccinated approaching herd immunity, investors have been predicting an explosive reopening of domestic economic activity. The initial rebound has past but the ongoing recovery still has legs. Expectations have been high for such measures as retail sales and industrial production. Bank of America CEO Brian Moynihan says consumer spending is 20% higher this year than 2019. In the past 24 months, total retail sales are up 10% per year, on average, versus a 3.6% growth rate from 2014-2019, supporting the case for strong economic growth, and further earnings growth.
The market’s upside has been driven by earnings (EPS), while multiples have been flat. The earnings recovery continues to set records for both strength and speed. S&P 500 companies have beaten consensus estimates at highest beat rates on record. 2021 consensus EPS continues to drift higher, as analysts underestimate the impact of fiscal and monetary stimulus, and the reopening process. Economic growth and consumer spending should boost corporate earnings over next 12 months. Every 1% increase in nominal GDP drives 3% increase in S&P 500 revenues. Economic forecasts imply higher revenue growth than analysts’ project.
Second quarter is also peak acceleration for earnings growth. The market needs to hear that companies are raising their forward guidance to avoid a sell-off this earning’s season. Over the long run, the stock market depends on earnings growth. Even though earnings growth rate peaks this quarter, earnings are projected to continue to grow by 12% in 2022 - 5% greater than the long-term average earnings growth.
S&P 500 valuation peaked last September and is declining as earnings set new records. Valuations are historically rich; however, ultra-low yields support richer valuations. When Fed starts hiking rates valuations will matter.
Where will the market likely go from here? Strong first halves for the stock market historically bode well for the remainder of the year. Whenever there has been a double-digit gain in the first half, the S&P 500 have never ended that year with an annual decline, according to Refinitiv data going back to 1950. What is more, the S&P 500 is up more than 12.5% to start the year, the second half has a median gain of 9.7%, according to LPL Financial data going back to the 1950s.
The third quarter is typically the weakest quarter for the markets. Big draw downs are most likely during the months of August and September. The stock market has been experiencing ongoing rolling corrections among its sectors which may help avert a full market correction anytime soon. Based on seasonal weakness, and markets progress so far, and valuations, I think the stock market is likely to hit a high in July and consolidate for the rest of the quarter.