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Market Review: Equity market strength continued into the first quarter as the Standard and Poor’s 500 stock index advanced 6.2%. Economic optimism and the continuation of the “reopening” trade supported broad participation across the U.S. market. Currently, 95% of the stocks in the S&P 500 are above the 200-day moving average of their closing prices signaling strong breadth and a healthy market. The Russell 2000 Small Cap Index doubled the S&P with a gain of 12.7%. Looking at overseas markets, the MSCI All Country ex-US Index gained 3.6%. A sharp rise in interest rates produced a 3.4% loss for the Barclay’s Aggregate Bond Index offsetting 2 1⁄2 years of income from the index. Gold fell 10%.
Positive Momentum: Domestic and global GDP are expected to top 6% this year which reflects massive government support, the rollout of vaccines, and pent-up demand. Oil rallied, the yield curve steepened and the more economically sensitive value category outperformed growth by the largest quarterly amount in history. Cyclical and financial stocks continued their momentum from the fourth quarter while the “pandemic” stocks took a breather. To cite a few examples, General Motors, Chevron, and J.P. Morgan rallied 38.0%, 25.8%, and 20.7% respectively, while Apple, Amazon, and Netflix declined by 7.8%, 5.0%, and 3.5% in the quarter. There remains plenty of potential catch-up on the table for value though this style rotation fizzled late in the quarter and into April. Your portfolio continues to span both growth and value factors.
Pulling Future Returns Forward? Investors have clearly responded to this positive backdrop as flows into equity funds dwarf previous periods, margin debt stands at extreme records, and short interest has plumbed new lows. Has the improved earnings outlook been priced in? Yardeni Research notes that the S&P 500 Index is trading at a record multiple of 2.7 times annual sales. Ned Davis Research ranks the 500 companies in the index to determine the median price-to-earnings ratio, and the current 33.9 median P/E stands three standard deviations above the long-term average. Using forward-looking data, the most bullish estimates for 2021 S&P profitability place the current P/E on forward earnings at 22, still well above the ten-year average of 18.9. A year ago, we kept a long-term perspective during the pandemic carnage, stating in our March 16th client email “Today, we see many blue-chip companies trading on our Bloomberg screens at what we conclude to be extremely attractive valuations. When we identify values like this, we are motivated to approach the volatility as an opportunity to invest on your behalf for the long term.” Today, while we are still finding some companies offering value, compelling opportunities are much more difficult to identify. This is certainly not surprising considering the S&P 500 is 80% above those March lows.
Inflation and Interest Rates: Low-interest rates and a very friendly Federal Reserve have been key pillars supporting high equity valuations. As a result, the most closely monitored risk to the market has been rising inflationary pressures which could force the Fed to be less accommodative. Over the past two quarters, the Goldman Sachs Commodity Index jumped 33.4% and the expected 5-year inflation rate jumped from 1.50% to 2.60% as indicated by the U.S. Treasury market. Nevertheless, the Federal Reserve has expressly stated that they believe inflationary pressures are “transitory” and that they fully intend to stand pat and remain behind the curve rather than ahead of the curve. The Fed is in a difficult position. The Fed has indicated that before they raise rates from 0%, they would first taper their program of purchasing $120 billion of U.S. Treasuries and mortgage-backed bonds every month. However, this program is in effect monetizing the deficit by boosting demand for the record issuance of Treasury debt. The $3 trillion increase in the Federal Reserve’s balance sheet over the past twelve months has coincided with a record budget deficit of $4.1 trillion as the government has responded to the pandemic. The Fed’s balance sheet stands at $7.7 trillion and now totals 40% of U.S. GDP versus 15% during World War II and 10% during the Global Financial Crisis. The coordinated monetary and fiscal support has been extraordinary, and it is impossible to predict how and when this massive intervention will be unwound. Significant asset volatility and dislocation will be a real risk, but if inflationary pressures do recede, the Fed will keep pushing that day out into the future.
We thank you for your trust and, as always, we welcome a detailed discussion of your investments.
YOUR STALEY CAPITAL INVESTMENT TEAM