Dow Jones Industrial Average
celebrated its 125th anniversary last week, but investors haven’t thrown over-the-top celebrations in honor of the milestone – or tantrums, for that matter. Major stock indexes have rebounded day by day, drifting slightly higher to extend a relatively directionless streak for the market to a second week.
The Dow Jones ended the week up 321.61 points to 34,529.45, up 0.94%. the
S&P 500 Index
gained 1.16%, to 4,204.11, while the
increased 2.06% to 13,748.74.
The path of least resistance for the market remains higher, and while investors may point many storm clouds on the horizon, they appear to be problems for another day.
“If you just look at the traditional valuation metrics, they are broad from history, and it’s easy to fall between safe and bearish,” explains David Donabedian, Chief Investment Officer at CIBC Private Wealth Management. “But we continue to have negative real returns across the entire yield curve. [quantitative easing]and the belief that, as good as the income estimates are for this year and next, they may still be too low. “
The S&P 500 has climbed 39% in the past 12 months, while the index’s futures earnings are up around 40%, according to
strategist Jonathan Golub. It can be an expensive market at around 22 times the earnings eventually, but it’s not just multiple expansion that is fueling the rally.
A booming US economy will be a continued tailwind for revenues – just look at last week’s retailer results – as much of the cost reduction for businesses in the pandemic era remains in the air. up, increasing profit margins in the recovery. In fact, the net forward profit margins of S&P 500 components are at an all-time high of 12.8%, according to Yardeni Research. Despite all the talk about cost inflation, pressures on the supply chain and rising commodity prices, companies seem to be doing very well in passing them on to their customers and keeping their margins intact.
It’s a tough scenario to bet against, Donabedian says: strong demand, profits likely to continue to rise, and a central bank still trying to prime the pump.
And those storm clouds? It’s no secret that the biggest threats to this high market multiple are interest rates and higher bond yields. The closely related inflation outlook and Federal Reserve policy will exert an even greater influence on the market in the second half of 2021.
Wall Street consensus predicts that the 10-year Treasury bill will return 2% or more by the end of the year, down from around 1.6%. Potential tax increases in the United States, setbacks in the global fight against Covid-19 and other negative wild cards abound.
“We’re at the peak of the good news that is already updated, but the bad news is not yet factored in, and we are entering a slower time of the year where people are going on vacation and trading volumes are declining,” declared Robert phipps, director at Per Stirling Capital Management. “It wouldn’t surprise me if the market falters for a while. “
The solution may be to focus on stocks and sectors that can benefit from overall favorable winds while remaining relatively sheltered from head winds.
This drives investors to the more cyclical and value-oriented sectors of the market. These are the companies most tied to economic growth, with cheaper valuations that are less sensitive to rising discount rates. This is not a new strategy — the
Russell 1000 Value Index
has beaten its growth equivalent by around 12 percentage points since the start of 2021. But it’s possible the trade will continue to operate.
Russell 1000 Growth
trades at a multiple points premium of 5.6 times over value, ”Golub writes. “It is currently trading at 10.3 times more.” Every point of the narrowing valuation spread would mean a 4% or 5% outperformance for value versus growth.
Valuations aside, many cyclical and value stocks emerging from a nightmare 2020 are able to post faster earnings growth in 2021 than the relatively isolated software and tech sectors from the pandemic, which face more difficult comparisons.
The market will not always be as calm as it has been in the past two weeks. Consider overweighting industrials, banks, materials and energy, and expect a better entry point for expensive, long-term growth stocks.
Write to Nicholas Jasinski at [email protected]