Investment Update: Where Will We Go from Here?

Jeff Mortimer, CFA, Director of Investment Strategy

While markets may be choppy in coming months, we remain bullish on equities and believe the market is correctly signaling sustained economic growth ahead.

It’s been an impressive year for stocks thus far. Most equity indexes are up double digits and the ride has been relatively calm. In fact, the largest drawdown on the S&P 500 index was only 4% peak-to-trough.  

Yet, clients continue to doubt the near 100% advance since the pandemic market lows, and question where equities will go from here. I can understand their skepticism given all there is to worry about: the Delta variant, peak earnings, fading stimulus, wage pressures, higher prices overall, and fear of higher interest rates – just to name a few. But as an investment strategist and student of history, I try to offer our clients my perspective on not only economic and market data but what the stock market may be signaling.

A Seasonally Soft Period

With the S&P 500 index up 18% year-to-date, we’ve been cautioning clients to expect not only more muted returns in this second full year after the market hit a low on March 23, 2020, but also some choppiness. As Exhibit 1 highlights, we are in the midst of a seasonally soft period for stocks relative to the S&P 500’s quarterly performance since 1928. The third quarter, while producing positive returns, has proven to be the most challenging for the index. 

Exhibit 1: +12 Month S&P Performance When >90% Above 200-Day Moving Average

Exhibit 1: Keep Seasonality Trends in Mind

quarterly performance of S&P 500Yet any near-term weakness could prove to be short-lived. Exhibit 2 shows what happens to equity market performance sequentially after a strong start to the year. Since the 1950s, after six or more months of positive returns, the S&P 500 performance has been positive one- three- six- and 12-months out. In fact, returns are positive one year later, four out of five times. It seems that momentum continues in markets once they begin the year strongly. While historically the reasons for the solid finishes have varied, we think the back half of this year might in fact rhyme with the past. 

Exhibit 1: Momentum Likely to Continue after Strong Start

S&P forward performance after positive streak

What Could Go Right?

Although investors worry about what could go wrong, it’s just as important to consider what may go right, as markets always weigh the odds of various outcomes. Here are four areas where I believe the market is signaling expectations for continued economic growth:

Earnings continue to grow but at a slower pace.
Corporate earnings continue to impress even against raised estimates, with earnings in the second quarter up over 88% from a year ago. Although the pace of earnings growth in the second half of 2021 is expected to be more challenging, we believe earnings may be up some 50% year-over-year. If so, 2021 earnings should easily surpass 2019 levels. And while the market expects earnings to peak in 2021, profit growth is still forecast to be positive in 2022. In fact, many analysts continue to raise next year’s estimates, signaling their opinion that companies have been able to reach such high levels of operational efficiency that more of their revenue translates directly to the bottom line. 

Liquidity remains elevated.
The fiscal and policy response to the pandemic has created incredible amounts of liquidity. Look at everything from savings rates – running at about twice their typical levels – to the $4.5 trillion in money market funds, and you see kinetic energy waiting to either spend or invest. Both are bullish for risk assets. 

Inflation proves transitory.
Early indications may support the thesis that inflation could be transitory. In fact, many commodities have not been able to hold their rapid price gains made earlier this year, suggesting that the supply side – initially unable to ramp up as quickly as the demand-side – is catching up. Abating commodity prices seem to be signaling that inflation’s bark might end up being worse than its bite. With that said, wage pressure – notably present in the services industries where companies are fighting for staff – will be worth monitoring, given it is historically stickier than other forms of price inflation. 

While we anticipate inflation will run hotter than the range of 0-2% we’ve seen over the past 12 years, it should by no means put an end to this bull market by itself. From 1991 to 2008, inflation ran between 2%-4%, and global equity markets did fantastically well during that period. (Maybe too well, as they bubbled twice during the technology move in the late 1990s and the housing bubble of 2008). The stock market has shown it can handle inflation running a bit higher than the recent range. Historically, it hasn’t been until inflation moves to 6% or higher – a range we do not expect – that it’s had a significant negative impact on P/E multiples. 

Interest rates remain well behaved.
Lastly, interest rates have remained well behaved during this year’s economic recovery. Despite the spike in the 10-year U.S. Treasury note yield to around 1.75% earlier this year, yields have continued to signal that inflation is most likely temporary. Yields may also be suggesting that concerns about overall levels of debt and new variants of the virus may continue to hinder hopes for a strong recovery. Finally, most forward curves on inflation continue to be downward-sloping, illustrating that inflation expectations seem well contained for now. 

Middle Innings of a Bull Market

I firmly believe we are in a new bull market; one that started on March 23, 2020. In fact, using history as a guide, I believe we are in the middle innings of this advance. Mid-cycle bull markets are mostly resilient in the face of bad news and can rally significantly if they are given something to cheer about. This current mid-cycle bull market appears to be no different, as evidenced by a sixth straight month of gains for the S&P 500 through July 31.

While a period of market choppiness may be upon us for the next couple of months, and a correction is always possible, we remain constructive on equities over the next 12-18 months. We recommend a slight U.S. bias within our small overweight to stocks over bonds. In our view, this market should be able to see past any of the many near-term worries and look ahead to a period of moderating but solid earnings growth, transitory inflation, and lower-for-longer interest rates. All of these trends should continue to help push equities higher. We believe any weakness should prove to be a buying opportunity. Just as market signals proved to be right last summer, we believe the market is once again correctly signaling sustained economic growth, although perhaps at a more moderate pace.

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