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Q2 2021 Market Update

Q2 2021 Market Update

Major U.S. equity indexes advanced higher in April hitting record levels. The S&P 500’s market breadth has been broad a sign that there are more gains ahead. But first the market may pullback in the face of overbought conditions and seasonally weak investment period ahead.

Major U.S. equity indexes advanced higher in April hitting record levels. Fundamentals behind the move were excessive government spending ($5 trillion), monetary stimulus, a successful vaccine rollout, exceptional corporate earnings growth, and stronger recovery prospects.

Market breadth is historically bullish. The S&P 500’s advance-decline (A/D) line has been making new highs too, a sign that gains are broadly spread across companies rather than a few tech companies. Board participation points towards further gains ahead. The S&P 500’s performance following past periods of healthy market breadth has been historically positive over next 12 months. However, Short term overbought conditions, extremely high Bullish investor sentiment, has left stocks vulnerable to a pullback before market advances higher.

In general, equities are not an attractive buy at current level, and neither are bonds. However, if you had to choose one over the other, equities offer greater return potential than bonds. Stock earning growth outweighs bond yields therefore buy stocks on any pullback. The bottom-up target price for the S&P 500 is 6% above the current level.

Earnings are projected to grow at 53% in second quarter! Analyst are revising upward future earnings at an accelerated rate. For 2021, analysts are projecting earnings growth of 26%, and profit margins 11%- exceptionally strong numbers way above average! Economic reacceleration, and a rebound in commodity prices are behind this unprecedented surge in profits. The ISM Indexes and other economic readings point to continued earnings beats.

Valuations are trading at the high end of their historical range for most indices which implies future returns should be lower than past returns. The Feds massive bond buying program is artificially lowering Treasury yields allowing for higher equity valuations than normal. Moreover, rapid earnings growth, modest inflation, Fed Funds on hold at zero, justifies higher than normal S&P 500 valuation for now.

While the fundamentals for the market are positive, investors are wondering if all the good news is priced in? U.S. growth will likely peak over the summer. However, the rest of the world is following the U.S. boom. Consumer spending should remain strong on the back of whopping pent-up demand throughout entire year. There are trillions of dollars in brokerage cash accounts, savings, and stimulus checks that can find its way into the stock market or be used to purchase goods and services (benefits stock earnings). Earnings, consumer spending, and economic growth will likely beat estimates. Lastly, job growth is accelerating!

I am watching the spread between the Ten-Years Treasury Yield and Two-Years Treasury Yield. If the spread remains below 200 basis points, currently its 140 basis points, then Bull market continues. The market is entering a seasonally weak period from May to October. A market pullback is in the cards especially at current market levels. Major market risks that would produce a correction include a Fed tapering, and President Biden's proposed hike in the corporate tax rate. In general, higher overall taxes results in lower long term economic growth, and are a headwind for stocks.
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