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Markets Fall 2021
U.S. major equity indexes pulled backed five percent in September; a month known for corrections. The pullback in stocks brought major indexes back to levels where indexes stood three months ago. Year to date stocks are outperforming bonds by a wide margin. Many bond sectors are on track for a negative year. The stock market enters a seasonally strong investment period by the end of October. I expect major equity indexes to move modestly higher in a choppy fashion into year-end.
Worries about the impact of the coronavirus' delta variant on the economy, supply chain slowdowns leading to shortages across a number of industries, and a regulatory crackdown in China, inflation and tapering fears conspired to slow U.S economic growth for third quarter. In turn, slowing economic growth and inflationary forces caused stocks to swoon by quarter end.
Fed tapering looks on schedule for November. The Federal Reserve’s tapering of its emergency bond purchasing program will not lead to a major sell-off for stocks. Tapering will be drawn out over eight months providing additional stimulus greater than QE-2 amount! The Fed’s balance will grow over Tapering period. Historically, big corrections occur when monetary policy changes are fast, and magnitude of hikes are large. Faster-than-expected pace of tapering heightens risk of a garden variety correction.
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 3 years according to Credit Suisse. The real damage from higher rates tends to occur later in the cycle when tighter policy inverts the curve.
The U.S. consumer is in its best shape in over a decade with healthy savings, low debt, higher 401-k balances, and home values. Moreover, wages are rising. Businesses are in even better financial shape. Corporate America Balance sheets and Income statements are as healthy as they ever have been. However, consumption is not rebounding as fast as forecasted. Supply constraints and Delta variant weighing on spending. Demand for products and services should recover as supply constraints resolve themselves and Delta-variant peaks.
Third-quarter earnings projected to rise 27.6% year over year, according to FactSet. That would be the third-highest growth rate since 2010. In the past five quarters, S&P 500 profits have topped estimates by 19%, as analysts underestimate demand, pricing power and operating leverage. Analysts and companies have been much more optimistic than normal in their estimate revisions and earnings outlooks for the third quarter. As a result, expected earnings for the S&P 500 for the third quarter are higher today compared to the start of the quarter. More S&P 500 companies have issued positive EPS guidance for Q3 2021 than average as well.
On the other hand, analysts are not revising their earnings estimates higher going into this earnings season and magnitude of beat rate is lower but still above average. Third quarter GDP forecasts adjusted lower, reflecting supply chain disruptions and labor shortages. It looks like supply chain shortages is peaking. Looking ahead at next year. Earnings and revenue growth projections are above average however, slip into single digits from high double digits. This trend warrants watching as higher corporate tax rate and waning fiscal and monetary stimulus could cause a market correction.
Business is still booming however rising inflation and labor costs, may crimp sales and profit margins. Strong demand cannot be met as supply constraints will not allow full production and pushing input cost up. Supply chain constraints are peaking but should carry over into next year. Peaking profits margins for companies are being squeezed by higher input costs which is a negative for future stock returns. The estimated net profit margin for the S&P 500 for Q3 2021 is 12.1%, which is above the 5-year average of 10.9%. So far nine of the eleven sectors are predicted to report higher net profit margins for CY 2021 today relative to June 30. Analyst are projecting earnings growth of 9.5% in 2022, and revenue growth of 6.6%. Both the ISM Service and Manufacturing Indexes are still at levels that support high earnings beat rate in 3Q and indicate expansion in the overall economy.
S&P 500 valuation at a P/E of 20 is rich given interest rates normalize faster than expected by markets, and earnings miss expectations. The 10 Year Treasury yield should rise to 2.0% in the coming quarters. Typically, higher yields compress stock valuations. S&P 500 Index Forward Price-to-Earnings ratio should decline to 19 from 20 in 2022 given lower earnings growth.
For the Stock market to enter a down market US economy must be heading towards a recession soon. Cyclical fundamentals do not support a down market. Credit markets lead equity markets, credit spreads credit spreads remain below normal. Net credit rating upgrades continues to move upward to the highest level since 2009 according to Bloomberg. Stocks move in opposite direction of spreads and same direction of yields. Yields are rising signaling that third quarter economic growth is just a soft patch.
Lastly, the cumulative A/D line, breadth and price are not diverging a sign that October’s pullback is not evolving into a correction and cyclicals should outperform going forward.
The global expansion expected to slow down in 2022 as world central banks taper. Removing liquidity, capital becoming more expensive, higher corporate taxes, should slow earnings momentum in 1Q22. The Stock market is vulnerable to a correction under those conditions. Also, forward returns will be lower under those conditions. The bottom-line, the stock market pullback should end in October on a solid earnings season and move modestly higher into year-end.
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