by Brad M. Weafer, CFA | Chief Investment Officer
Executive Summary
- The S&P 500 is up 20% this year with little to no volatility
- The outlooks for the economy and earnings growth is strong
- Certain risks are apparent, but BFM’s outlook for stocks remains positive
2021 has been a remarkable year for U.S. equity markets. The S&P 500 returned more than 20% through the end of August, for the first time in over 20 years. August marked the seventh straight positive month for the index, with a new high reached every single month. The market’s advance has been relentless, with more new highs achieved during the first eight months of the year than ever before. The march higher has been devoid of almost any weakness, without even so much as a 5% decline in the index since last October. The stock market is 38% higher since that last correction (See Figure 1).
The gains have many asking if the market has gone too far. While we haven’t left Covid-19 impacts completely in the past, the economy has made significant progress. The pandemic-induced recession is over. We are currently experiencing impressive economic growth. The recession was both historically short and unique, with personal income per capita and personal savings rates increasing during the economic decline, a first by our review of modern recessions. The labor market has since recovered, and pent-up demand was released with the reopening of the world. Spending rallied sharply, driving economic gains, and real gross domestic product (GDP) increased at an annual rate of 6.6% in the second quarter of 2021. This supports a fantastic environment for corporate profit growth. In the most recently reported second quarter, companies in the S&P 500 reported 89% earnings per share growth, and estimates for calendar year 2021 suggest 50% earnings growth over 2020. The base effects on depressed 2020 levels make these figures look eye-popping, but the growth over pre-pandemic levels is quite impressive. Estimates for 2021 earnings per share are over 34% ahead of 2019 levels (according to Goldman Sachs estimates, See Figure 2). This is consistent with the 39% increase in the S&P 500 experienced from pre-Covid levels, reminding us once again that earnings are the ultimate driver of equity prices.
Looking ahead to next year, the outlook for both the economy and earnings is sound. The Conference Board forecasts economic growth of 4% annually in 2022 (after 6% in 2021). This is consistent with Wall Street consensus estimates of 4.3% growth. Consecutive years of outsized growth, following a 3.4% rate of decline in 2020, is a continued positive environment for profit growth for corporations. We see an even brighter outlook for our portfolio companies, where we expect higher revenue, earnings, and dividend growth for our holdings relative to the average company.
By comparison, low-risk government bonds offer little nominal return and are not compensating investors even for low inflation. The extra return offered by corporate bonds (both investment grade and junk-rated) to assume the additional risks of default remain at cycle lows. This combination leads to very low rates of expected return from fixed income. While fixed income allocations in balanced portfolios continue to offer a hedge against equity volatility, the low-rate environment leaves our return and income expectations for bonds very modest. As a result, our suggested portfolio weights continue to be biased to equities relative to long-term individual client targets.
Our positive outlook for stocks is not meant to suggest there aren’t risks worth considering, however. The overwhelming number and tone of negative headlines on the rise of Covid-19 variants have been dizzying. Our view of the data is vaccines are effective and have limited the severity of infections leading to hospitalization and mortality. We already see signs the delta wave has begun to recede and do not see a case for new measures that would impede economic growth. Labor constraints, supply chain backups, and the associated inflationary effects have remained stubbornly persistent, threatening the outlook for corporate operating margins which are at record highs. The latest signs we see suggest those pressures are beginning to ease, and the companies with pricing power should experience durable margin. Federal policy makers are set to withdraw some of the record levels of stimulus provided through the pandemic and may raise taxes, a hit to corporate after-tax profits. Here again we see this risk as measured and currently proposed tax cuts will lessen earnings growth but will not erase gains that we expect for next year. Monetary policy is also set to gradually tighten as growth and labor conditions improve. Any increase in interest rates as a result could prove a headwind for equity valuations, which are already at elevated levels. This risk too seems well understood by market participants, and any increase in rates likely coincides with a more durable growth outlook. Risks aside, the lack of market volatility exhibited this year is historically rare. We do not expect this calm to continue indefinitely. The bigger picture however remains that the economy and earnings are in the early phase of an expansion cycle that is favorable for stocks.
With such a strong start to the year already in the books, history is on the investors’ side. In the last fifteen instances where the S&P 500 returned over 15% by the end of August, the stock market only declined in the next four months of the year twice (See Figure 3). The market advanced on average 6.7% in the thirteen other instances. Despite the many reasons to expect things to go less smoothly than recent times, the broad outlook for stocks remains encouraging.
Market Commentary Disclaimer
This publication is for informational purposes only and should not be considered investment advice or a recommendation of any particular security, strategy or investment product. The information contained herein is the opinion of Boston Financial Management and is subject to change at any time based upon unforeseen events or market conditions.