Stocks have one of their greatest years of gain per pain unit, with S&P 500 increasing 20 percent not even two-thirds by 2021 without a downturn of 5 percent.
The index is poised to post a seventh consecutive monthly gain, the first time this has occurred from February to August, while also tracking toward three consecutive months of at least a 2% increase. According to Instinet, such three-month runs have only occurred 13 times since 1990, with two of them occurring in 2021.
And, along the way, corporate earnings have outpaced expectations to the point where the market’s valuation based on current, higher forecasts is lower than it was a year ago; the market has become less expensive the easy way.
Speaking of easy, Federal Reserve officials have deftly guided investor expectations toward a start to tapering the Fed’s $120 billion-per-month bond-buying program late this year or early next year, without inducing a stress response.
Chair Jerome Powell hinted at such a timetable on Friday morning if the economy remains on track, but he also pushed the view that high inflation readings would recede and that tapering has no bearing on an eventual rate hike. The market continued to nod along, with Treasury yields easing and stocks ripping 0.9 percent to a new high.
Even the summer surge of the delta Covid variant, which caused an alarming amount of additional human suffering, was unable to derail the uptrend, which occurred just as investors’ concerns were focused on the possibility of the economy overheating.
Dip-buying reflexes that are aggressive
No one wants it, but the market expressed concern about the growth-stifling effects of soaring global Covid infections by selling off overextended cyclical and “reopening” stocks and refocusing on the S&P 500’s all-weather growth stocks. Localized corrections in bank, transportation, homebuilding, small-cap, energy, and semiconductor stocks reset their valuations and frightened investors just enough to keep their enthusiasm in check.
The longer the indexes advance, the stronger the dip-buying reflex becomes. This chart from BCA Research depicts S&P 500 pullbacks from highs since 2015, highlighting the ever-shallower retreats since last year’s February-March crash.
A similar, but longer, period of scant setbacks lasted from late 2016 to 2017, another post-election year of fiscal-policy excitement, nominal economic growth reflation, constant sector rotation, and a predictable Fed.
As noted here in February, “we can’t yet rule out the possibility that this will be like 2017 or 2013 – the previous two post-election years, when the market stayed on an upward grind and offered few opportunities to buy in on a sharp break.” We’re glad we didn’t rule it out.
(Recall that 2013 was the year of the so-called Taper Tantrum, in which markets initially reacted negatively to the Fed’s announcement that it would end its quantitative easing program before settling into a pulsing, low-drama climb.)
So, while the market’s reward-to-risk ratio may feel “as good as it gets,” it isn’t even as good as it was four years ago.
Of course, four years later, the cumulative superlatives are more extreme. The S&P 500 is now trading at 4500, which is three times the 1500 level that marked the major peaks in both 2000 and 2007.
Perhaps more surprisingly, the index has gained an annualized 16.4 percent since the bottom of the bear market in March 2009. That’s a percentage point higher than the index’s annual rate of 15.4 percent from the October 1987 crash low to the generational peak in March 2000. Those periods lasted nearly the same number of days, just over 4,500.
This chart of the S&P 500’s rolling ten-year total returns over nearly a century shows the market pushing into the upper range of trailing decade-long gains.
So – for real this time – what more could an investor reasonably expect from the market from here?
Where do we go from here?
In the short term, strong and persistent rallies tend to give way to even more strength in the months that follow. None of the previous 13 three-month streaks of at least a 2% gain ended at a significant market peak. According to Instinet, the S&P continued higher the following month in eight of the instances, with the average one-month return of all instances being 1.7 percent.
The 2017 tape – a similar tenacious upward grind with few pullbacks – culminated in a furious fourth-quarter melt-up that lasted three weeks into January 2018, creating a simultaneous crescendo of price momentum, investor enthusiasm, and cycle-high valuations before a severe vertical break that featured rampant bets on low volatility blowing up.
That isn’t the only way for strong rallies to end, but current conditions don’t fit with that buying frenzy, with sentiment not yet exuberant and the indexes not as blatantly overbought as they were back then.
In terms of long-term returns, major bull market cycles have tended to end with trailing annualized ten-year gains hovering in the teens, rather than just briefly bobbing up there. Which may provide some solace, even if the forces of mean-reversion become less favorable to equity performance in the coming years.
Of course, these are just trends and precedents, not a precise forecast of the current market drivers. It’s difficult to avoid the looming sense of past-peak conditions across multiple vectors. Peak reopening acceleration, peak policy tailwinds, peak earnings growth, and, most likely, peak credit-market generosity
All of this, however, does not imply a peak in equity prices as long as the economy is moving forward and profits are increasing. Profit forecasts for the third and fourth quarters are likely still too low, but the typical pattern after a massive profit rebound is for year-ahead estimates for 2022 to begin too high, at a time when the S&P is trading at a robust 21-times forward 12-month profits.
Cantor Fitzgerald’s head of equity derivatives and cross-asset strategy, Eric Johnston, last week shifted from a steadfastly bullish to a neutral stance on US stocks, his 4400 S&P target from late last year once the highest on the Street. The reasons for the downgrade include, among other things, elevated investor equity exposures, past-peak growth, September’s poor historical returns, and fiscal-spending drag in 2022, which together mean that stocks are not doomed, but that “the time to close your eyes and just own equities is now over.”
Given all of this and how far the indexes have traveled, a somewhat stingier, more uneven market in the not-too-distant future should come as no surprise.
Yet, for the past 17 months, this market’s surprises have all been positive, despite the fact that it was possible to argue that it had come too far, too fast.
S&P 500 hits 4,500
Yes, volume is light, momentum is lacking, and market breadth is improving but remains underwhelming. Bull markets, on the other hand, find a way, and as a reminder, boring is bullish for stocks. There is still a preference for quality stocks over beta or maximum cycle leverage. It makes sense at this point, after massive 17-month equity returns and entering the Fed’s normalization zone with some “fiscal drag” thrown in.
The S&P is beginning to nudge against its upper trading-range band here, suggesting that 4,500 may be more of a destination than a launch point in the near term. However, over the last few years, we’ve seen the index ride these bands higher before pulling back or flattening out.
Bond yields are likely to relax higher due to a receding delta Covid surge and a retracement of the Treasury rally, which drew excessive inflows into bond ETFs in recent weeks ahead of the Fed’s Jackson Hole conference. The implications of a taper timeline for yields are unknown; in previous cycles, the end of quantitative easing resulted in long yields. But that was after it started, not before it started.
The 10-year is at a fun decision point, sitting at the intersection of its 200-day and 50-day averages, as well as the downward trend line from the springtime peak.
Generally, the market has been tracking higher corporate earnings while slightly compressing equity valuations from high levels. The consensus estimates for 2021 and 2022 are still rising (second-half 2021 EPS is lower than first-half reported levels, so there is probably still room for more upside), but the angle is flattening, and the typical pattern for next year is that year-ahead forecasts begin too high. However, much about this cycle has been unusual.
In terms of positioning and sentiment, investors are collectively heavily invested in stocks, with equity allocations near historic highs and inflows robust throughout the year until the last few weeks. The options market is becoming complacent. We are not well-equipped to deal with an unfavorable headline or a minor financial “accident.”
However, tactically, the mood has changed, and with the indexes at highs, I see very little excessive optimism or wild risk-taking outside of the NFT playpen and occasional outbreaks of meme-stock buying raids. Professional market advisors are less optimistic about stocks than they have been in a long time (poor market breadth, delta, and Afghanistan weighing on attitudes?). In the weekly Investors Intelligence poll, bulls outnumber bears:
Market breadth is solid, but not as strong as it has been the last two days.
The slender daily moves and index resilience are weighing on the prices of protective index options. There is still a slight “non-confirmation” of the S&P at highs without the VIX at recent lows. Probably Jackson Hole ahead, plus the lingering caution that August-September are notoriously volatile months for market storms.
Nasdaq rises above 15,000
According to Bespoke Investment Group, the Nasdaq Composite closed above 15,000 for the first time on Tuesday, the third 1,000-point milestone this year and the sixth since the pandemic began in 2020. The Nasdaq rose again on Wednesday, gaining about 0.1 percent to 15,041.
In 2021, the Nasdaq is up 16.7 percent, while the S&P 500 is up 19.7 percent.
Because technology makes up such a large portion of the Nasdaq, it must perform well, and some analysts believe the sector and growth names will contribute less to overall market gains in the future. Because the economy is expected to improve, cyclical names such as industrials and materials have more room to grow than tech.
“I just think the cyclicals…will give you a better relative return into year end,” RBC Wealth Management technical strategist Robert Sluymer said. “It’s all part of the ebb and flow between cyclicals and growth….” Many of these cyclicals have been severely impacted, and at least technically, they are nearing the bottom.”
According to Sluymer, the 10-year Treasury yield will be a deciding factor. The rate has been rising, which could dampen tech’s gains. The yield, which was 1.34 percent on Wednesday, is important because it is linked to important mortgage and other lending rates.
However, the benchmark yield has an impact on the stock market, particularly in the tech and growth sectors, because the best earnings of those companies are expected in the future. A higher yield raises the cost of capital and reduces the value of future cash flow.
“Perhaps the dynamics within the Nasdaq will change,” said Ron Temple, head of US equities at Lazard Asset Management. “I believe the broad market… is in an environment conducive to continued appreciation, though not at the rate we’ve seen.”
According to Temple, interest rates will rise, and the 10-year yield does not reflect the economy’s current strength. Yields move in the opposite direction of price, so when the bond market reacts to positive economic news, prices typically fall while yields rise.
“I do expect a rotation back to near-term cash flows over long-term cash flows… that may translate to value outperforming growth,” Temple said. “But that doesn’t mean I’m opposed to growth.”
Over the last month, technology has gained 1.8 percent, but some cyclicals have performed better. Financials are up 6.6 percent, and materials are up 4.4 percent in the last month. Since July 1, technology has risen 6.5 percent, while financials have risen only 5.2 percent. Materials have increased by 3.6 percent during that time period.
In addition to favoring value over growth, higher rates may cause a schism within the tech industry. “There are parts of the Nasdaq that are more vulnerable,” Temple said, noting that large-cap companies that generate a lot of cash flow could continue to do well but not rise as quickly as they have.
According to Temple, the types of companies that could be vulnerable are those where investors are betting on cash flow in five to ten years, but there are currently low revenues and even losses. With a 1.5 percent interest rate, $100 in cash flow would be worth $86 in ten years, but if rates rise to 2.5 percent, the cash would be worth $78, he said.
“I actually think some of the big tech companies are still values,” he said. He also stated that the market environment is favorable, with the Fed unlikely to raise interest rates anytime soon.
Ari Wald, a technical strategist at Oppenheimer, predicts that the Nasdaq will rise even higher. While cyclicals and value may outperform, Wald believes that long-term tech is more important because it will make more consistent gains.
“If interest rates rise, technology will not necessarily be the best performer. You may see the market embrace beta and these reflationary names,” Wald said, adding that technology should continue to rise.
“It will be the semiconductor side of technology that does well in that sort of environment,” he predicts.
A large round number
The actual 15,000 level on the Nasdaq is not particularly significant, though it is psychologically significant. According to National Securities chief market strategist Art Hogan, it is important because every big round number makes headlines, which helps inform a broader group of potential investors about market performance.
According to Hogan, the Nasdaq has gained 19 percent since March and may be impacted by another shift away from technology and growth. This could benefit broader market indexes like the S&P 500, but it is also influenced by big tech names like Apple and Microsoft.
“I think big round numbers attract attention from places other than where people are glued to every single tick,” he said.
He, too, anticipates that technology will take a back seat to cyclicals and growth. “I believe that is due to the better news we have seen sequentially since July. I believe the improvement in economic data, higher earnings revisions, a possible peak in delta cases, and the credible possibility of Congress passing the next infrastructure plan,” he said.
Hogan believes the market will continue to rise, and that it is now cheaper than it was earlier in the year due to earnings revisions that lowered the price-to-earnings ratio. The S&P 500’s 12-month forward P/E ratio is 20.5, but it was 23 in April, according to him. On Nasdaq, the forward P/E ratio is 28.5.
“It shows you how much earnings have grown and how much estimates have increased for the second half of the year,” he explained.
With the exception of 6,000, the Nasdaq has fallen back below every thousand point mark it has reached, according to Bespoke. After trading above 5,000 in March 2000, before the tech bubble burst, it took another 6,256 days to trade above 6,000 in April 2017.
“Since then, however, the Nasdaq has made quick work of 1,000-point thresholds. With the exception of the 486-day gap between 8K and 9K, every other 1,000-point threshold since 6,000 has taken less than a year to cross. Even in the midst of a global pandemic, it took the Nasdaq less than six months to rise from 9,000 to 10,000,” according to Bespoke.
The head of BlackRock’s global allocation team said Thursday that he isn’t concerned about the stock market’s level after a dramatic run over the last year and a half.
“I don’t believe the equity market is overvalued at all. “I mean, look at some of the companies, their free cash flow yields are really high,” he explained.
Rieder cited strong earnings reports from retailers and profit margins at technology firms as evidence that the return on equity for many stocks remains attractive even as market indexes reach new highs. He did admit that some stocks were overvalued, but not the market as a whole.
“That’s not to say we can’t reprice down a bit if the Fed says something hawkish, but markets will bounce back,” he added.
The real source of concern for overvalued assets, according to Rieder, is the fixed income sector, specifically lower quality debt.
Fed Chair Jerome Powell will deliver a virtual speech at the central bank’s annual Jackson Hole summit on Friday. He could reveal when the Fed will begin to reduce its asset purchases. Rieder, who also serves as BlackRock’s chief investment officer for global fixed income, believes the Fed is late in tightening monetary policy and should try to accelerate rate hikes, which many investors believe will occur in 2023.