Equity Market May Be Entering A Period Of Further Strength

Going back to 2016 I was writing about the current bull market that began in 2013 and how it resembled the bull market of the 1950's and 1980's. At the time of those earlier posts I certainly did not foresee the pandemic and a .5% yield on the 10-year U.S. Treasury. Nonetheless, as this current recovery unfolds, a rise in the 10-Year U.S. Treasury yield has occurred and may continue. Higher interest rates in and of themselves are not necessarily a headwind for stocks though, especially when rising from a very low level.

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Earnings Growth Supports Strong Equity Market Advance

Fourth quarter 2020 earnings reports are nearing an end as 495 companies in the S&P 500 Index have reported results. Refinitiv's report dated March 5, 2020 notes results have come in better than history. Nearly 80% of companies have reported earnings above analyst estimates, exceeding the long-term average of 65%. Expectations for the next two quarters shows earnings growth accelerating with the second quarter 2021 estimate currently indicating growth of 51.2% on a year over year basis.

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Spiking The Punch Bowl

A nearly $2 trillion Covid relief package is working its way through Congress. There is differing commentary about the amount of the stimulus that is going to "Covid" relief, but assuming much of it is relief in some form or the other, how does it get spent? Is the relief targeted? In aggregate the stimulus that has been sent to individuals prior to this most recent package does not all seem to have been spent. The below chart shows the spike higher in the savings rate, currently running over 20% of disposable personal income.

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Economically Sensitive Stock Market Sectors Lead Performance

A look at S&P 500 Index sector returns after the market close on Thursday shows since the March 23, 2020 low, energy is the top performing sector up 117.6% and followed by materials and financials. The industrial and technology sectors round out the top five performing sectors as seen below.

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Travel And Leisure Companies Should Benefit From Satisfying Pent-Up Demand

The travel and leisure segments of the market may be some of the most value oriented ones as their business has essentially been shutdown due to the COVID-19 virus. As the global economy began to be shuttered in February last year, travel companies like Carnival (CCL) and Norwegian Cruise Line (NCLH) experienced significant price contractions as seen in the below chart. When comparing their returns since the beginning of 2020, many of the stocks remain down far more than the broader market or S&P 500 Index. One outlier is Expedia that is up 49.5% versus the S&P 500 Index return of 20.4% since the beginning of 2020.

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Value Stocks Outperforming For Now

Large cap value stocks have come to life this year after underperforming growth for most of the last 15-years. As the below chart shows, the Invesco Pure Value Index (RPV) is up nearly 15% this year compared to the Invesco Pure Growth (RPG) Index return down .12%.

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Interest Rates Pressuring Bond Returns

It is not uncommon for the yield curve to steepen as the economy exits a recession and transitions into expansion mode. After another Fed induced yield curve inversion in August of 2019, the economy dipped into a recession at the end of 2020. Certainly the pandemic shutdown contributed to the recession, but possibly the economy was headed in that direction anyway following the yield curve inversion.

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High CEO Confidence Not Reflected In Consumer Confidence

Last week the Conference Board reported the Measure of CEO Confidence for the first quarter of 2021 at 73, a 17-year high for the reading. A as the Board notes, readings above 50 reflect there were more positive than negative responses. The survey was conducted January 14 through January 29. As reflected by the consumer though, the Conference Board's reading shows consumer confidence at 89.3 and far below the 135 reading prior to the pandemic induced recession. The consumer reading is anticipated to be updated in the coming week. Of significance is the fact other consumer confidence and sentiment readings, like University of Michigan's, also show lower levels of consumer confidence.

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Continued Deterioration In Small Business Optimism

Today's Small Business Optimism Report by the National Federation of Independent Business (NFIB) shows continued deterioration in business owners optimism in January. The Index fell .9 points to 95.0 versus December's reading and taking it below the 47-year average of 98. The quarter over quarter absolute change is a minus 9 points and is the largest change since the -13.4 and -10.1 point change in April and May of 2020.

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A Weaker Jobs Recovery Seems To Be Unfolding

In a post I wrote in late January I noted the headwind that an increased regulatory and tax burden is likely to have on economic growth. Last week's jobs reports provided further evidence that a slower economic environment may be taking hold. As the below chart shows, the level of employment seems to be trending sideways and is approaching the trajectory of the slow job recovery following the financial crisis in 2008/2009.

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Most Shorted Stocks Power Higher

At the end of November last year I highlighted the fact the most shorted stocks had started to gain momentum at the beginning of October. Fast forward to the start of February and Refinitiv's U.S. Most Shorted Stock Index has continued to generate outsized gains. For the last four months the Refinitiv U.S. Most Shorted Index is up 92.8% versus 10.4% for the S&P 500 Index. Half of this gain has occurred in January with the Shorted Index up 40% as seen in the second chart below.

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Retail Traders Inflict Pain On Some Hedge Funds

Last week investors were reintroduced to the terminology of  'short squeeze' and 'gamma squeeze'. It has been some time since the phrase gamma squeeze was bantered about as much as it was last week as the volatility in a few stocks captured headlines. Stocks like GameStop (GME) and the movie chain AMC Holdings (AMC) saw their stock prices swing widely, but mostly to the upside. So what is going on with a few stocks like this.

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Dividend Aristocrat Changes For 2021

S&P Dow Jones Indices announced the results of its annual rebalancing of the S&P 500 Dividend Index. Three companies are being added in this rebalancing and three are being removed, leaving the number of Dividend Aristocrats at 65. The changes go into effect prior to the market open on February 1, 2021. As noted by S&P, "S&P 500^® Dividend Aristocrats^® measure the performance of S&P 500^® companies that have increased dividends every year for the last 25 consecutive years. The Index treats each constituent as a distinct investment opportunity without regard to its size by equally weighting each company." In addition to the dividend increase requirement, other factors S&P Dow Jones Indices includes in the methodology to select the dividend aristocrats are:

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Foundation For Slower Economic Growth Being Laid, Stocks Still Work

In our Winter 2020 Investor Letter released earlier this month, our firm indicated our real GDP growth expectation for this year is in the mid single digit percentage range. We continue to hold that view given likely pent-up demand and our expectation the economy is exciting the recession. The uncertainty around the virus spread and vaccination progress is a headwind to our growth expectation though. Additionally, before the inauguration of President Biden on January 20, I highlighted the potential risk of a policy error to the economic recovery. Some of the executive orders (EO) signed by the President after he was sworn into office on January 20 now heighten this risk in my view. For investors it is important to separate their political/policy concerns with the view of the performance of the investment markets.

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Maybe Time To Include Dividend Growth Equities To One's Portfolio

The broadening in performance across multiple equity asset classes is providing investors with investment opportunities outside of the S&P 500 Index. The S&P 500 Index has certainly been a stalwart in terms of performance over the last five and ten years. Given the strength in the equity market and the index trading at valuation levels that some call stretched, investors might consider dividend paying stocks for a portion of their portfolio. One characteristic of dividend payers is they generally hold up better in down equity markets.

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A Policy Error Could Trip Up Stocks

Broadly investors have enjoyed strong returns in stocks over the past two years, the S&P 500 Index returned 31.5% in 2019 and 18.4% in 2020. Last year's return occurred in an environment where earnings for S&P 500 companies is expected to equal $133, down from $157 in 2019. This move higher in stocks at the same time earnings declined has pushed large company stock valuations to levels where one might say they are priced for perfection. One way to look at stock valuations is reviewing a measure called the Rule of 20 which states that stocks are fairly valued when the inflation rate plus the price earnings ratio of the S&P 500 Index equals 20. As the below chart shows this measure currently equals 23.4. If one uses the P/E based on the index's 2022 earnings, the measure equals approximately 20.4.

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Small Business Optimism Turns Decidedly Negative

The NFIB Small Business Optimism Index turned decidedly negative in December. The index fell 5.5 points to 95.9 and is below the index's long run average of 98. NFIB reported 9 of the 10 index components declined. The survey report notes, "The drop in small business optimism was historically very large...Most of the decline was a result of substantial weakness in the outlook for sales and business conditions in 2021 which brings new Covid threats and the uncertainty about economic policy with a new administration in Washington." Small business owners excepting better business conditions over the next six months came in at minus 16, a 24 point decline from the month earlier and the second largest drop since 1986.

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Broadening Participation In Equity Market Asset Classes

One favorable aspect of the recent equity market performance is the broadening participation of asset classes other than the large cap FANGMA stocks, Facebook (FB), Amazon (AMZN), Netflix (NFLX), Google (GOOGL), Microsoft (MSFT) and Apple (AAPL). As the below chart shows, during the first eight months of 2020, the average return of this basket of stocks significantly outpaced the other asset classes shown on the chart.

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Winter 2020 Investor Letter: From Pandemic To Transition

The just completed year of 2020 saw the S&P 500 Index increase a strong 18.4% and this is on the back of a 31.5% return in 2019. One might not have expected this with a large number of state economies constrained by virus mandated restrictions early in the year. For the five calendar years from 1995-1999 the S&P 500 Index returned 20%-34% in each year. Could the market be in for a repeat of that type of performance? The so-called roaring 1920’s occurred after the Spanish flu of 1918/1919; partially a result of satisfying pent-up demand.

Our Investor Letter touches on some of these topics and our viewpoint on the year ahead.

• Winter 2020 Investor Letter

Stock Buybacks Increase As Reported Earnings Jump

S&P Dow Jones Indices' recent report on buyback activity for the third quarter shows buyback activity increasing to $101.79 billion from $88.66 billion in the second quarter. With the economy mostly reopening, at least through Q3 2020, companies reported an improvement in 'as reported earnings,' increasing to $273.2 billion versus $98.5 billion for the first quarter. As the red line in the below chart shows though, buybacks remain far below the fourth quarter 2018 peak of $222.98 billion.

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