Market Commentary - Q1 2021
Summary
Gains were widespread for a second consecutive quarter, a strong signal that the bull market is alive and well. Small cap stocks outperformed. Many of the trendiest stocks from the “stay at home” theme saw their momentum stall around the middle of the quarter and are now down for the year, while a major rotation to reopening names in the travel and leisure, energy, industrial, and financial sectors posted strong gains for the Q1 2021.
Speculative fervor among retail investors remained heightened, highlighted by the Reddit-driven GameStop saga, and rising cryptocurrencies.
Bond yields rose much quicker than expected during the quarter as investors questioned whether even more stimulus will lead to inflation.
Melt down in VIX. Melt up for equities.
The volatility index (VIX), a measure of the real-time market index representing the market's expectations for volatility over the coming 30 days, fell below 20 on February 12 for this first time since the pandemic began. We saw a spike in the VIX and a correction in equity markets during February and March, before forming what appears to be a new sub-20 range for the VIX.
We believe that a gradual melt down towards mid-to-low teens in the VIX will translate to a gradual melt up for equity markets.
Broad based rally
As the pandemic hit, technology and work-from-home stocks surged. As positive vaccine news hit, reopening stocks such as travel and leisure surged. As bond yields went up and inflation ticked up, cyclical stocks, like financials and industrials, rose.
Now we are seeing a broad based rally across industries in US markets. This is a very different and important story than what has led gains in the past year. Oftentimes a signal of a strong bull market that is in its early stages.
Strong economic data
The US economic recovery is accelerating as stimulus money, Covid-19 vaccinations and business re-openings spur a spring surge in consumer spending, a sharp pullback in layoffs and a bounceback in factory output.
Retail sales jumped 9.8% in March. The gain in consumer spending, the biggest driver of economic activity, came as the government began distributing hundreds of billions of dollars of stimulus funds to households. It was the largest monthly gain since last May, during the initial recovery from lockdowns early in the Covid-19 pandemic. The gains in retail sales last month were broad-based, and showed a robust spending pickup in some categories that suffered early in the pandemic as people stayed at home to avoid the coronavirus.
Jobless claims have beat expectations significantly two weeks in a row, showing a faster pace of hiring in the leisure and hospitality industry. While claims are still above levels that prevailed early last year, last week’s figure was the lowest since March 2020. The total number of people receiving benefits also fell across a range of state and federal pandemic-related programs.
Industrial production, a measure of factory, mining, and utility output, rebounded in March after a decline in February. Factory output, which rose 2.7% over the month, helped drive the gain.
The economic readings taken together reflect people going back to work, people seeing more income, and people spending; this is strong support for America’s economic resilience.
Strong corporate earnings
A strong start to earnings season from banks and other financial companies has combined with data showing the economy is growing at a rapid clip to propel stocks higher this week. Adding to the momentum: A drop in yields on U.S. government bonds that has surprised some investors in its size and speed.
As of April 27, 153 companies of the S&P 500 have reported earnings so far. Of these 153 companies, 88% have beat earnings estimates with an average earnings beat of 17.2% and forward guidance has increased by 60%.
During the pandemic, share buybacks have been put on hold for many companies, including banks. We believe share buybacks will come back in a major way as these restrictions are lifted. Another positive for US equity markets.
Reflation rotation
Growth stocks dominated value over the last decade, especially in 2019 and the first half of 2020. Six months ago, mega-tech stocks were firmly in control, having held up better in the pandemic sell-off and driving an outsized portion of the recovery. By late summer of 2020, the price premium of growth over value had reached all-time extremes based on some measures.
Over the last two quarters, however, the Russell 1000 Value index has outperformed its growth counterpart by almost 20%. The three largest stocks (Apple, Microsoft, and Amazon) have lagged the broad market in this period.
What drove this?
- Positive vaccine developments accelerated the expected timeline for the return of the physical economy and a reversal of the “stay at home” trade.
- Massive fiscal and monetary stimulus are pushing up interest rates, making growth stocks whose earnings will be concentrated farther in the future less valuable.
- Rising inflation could favor value-oriented sectors.
- Many growth stocks may simply have become too expensive.
Valuations for the mega-cap tech stocks are high but can be justified given their high growth rates and the low interest rate environment. Apple, Microsoft, Google and Facebook all trade at a price to sales ratio of roughly around 10 and a PE roughly around 30. Whether these multiples remain supported is critical because the top five stocks account for almost 20% of the US equity market and 40% of the growth universe, as of the most recent quarter end. The correction in mega-cap tech in February/March was healthy and a lot of these stocks are bouncing back strongly after posting impressive earnings.
Another important group of growth stocks trade at higher valuations and more extreme sentiment. This includes favorites from clean energy, biotech, cloud computing, electric vehicles as well as several recent IPOs. This is the part of the market where speculative fervor is at its highest and we see high risk in this group. Still, the combined weight of these day trading favorites is a relatively small part of the market overall.
For diversified investors all of this poses little risk. But we fear many investors do not appreciate the potential volatility of their holdings. If some of these momentum superstars start to tank, it could create a chain reaction. Many holders of these companies have similar portfolios and frequently apply leverage.
Goldilocks economy?
In his annual letter to shareholders Wednesday, JPMorgan CEO Jamie Dimon said strong consumer savings, expanded vaccine distribution and the Biden administration’s proposed $2.3 trillion infrastructure plan could lead to an economic “Goldilocks moment”, classified as an economy with fast, sustained growth alongside inflation and interest rates that drift slowly upward. The leader of America’s biggest bank said the U.S. economy is emerging from the coronavirus pandemic into a boom that could last until 2023.
BlackRock CEO Larry Fink said he’s optimistic about financial markets as the economy attempts to recover from the coronavirus pandemic. “I am incredibly bullish on the markets,” Fink said in an interview on CNBC. He noted that a host of factors, including monetary stimulus, fiscal stimulus, cash on the sidelines, and strong earnings are likely to propel markets higher in the near term, even as the S&P 500 and Dow Jones Industrial Average hover near record levels. “A big reason why there’s so much cash sitting on the sidelines during Covid and during remote working our behaviors have changed dramatically,” Fink explained, noting the amount of money many commuters are saving by not going into work.
“Whether the money is coming from a stimulus check or is coming from savings or behavior changes for savings, I think it’s fantastic that we’re seeing more people either investing for the long term or even trading,” he added.
Tax Increases
Potential pending tax increases are also a significant risk factor. On the last day of the quarter, President Biden outlined a $2.25 trillion spending bill to be funded largely by an increase in individual, corporate, and capital gains taxes.
What could be proposed?
- Capital gains taxes – Bloomberg has reported that Biden will propose treating capital gains as ordinary income for people earning over $1 million. There have been differing reports regarding what “earning over $1 million” means. This could be anywhere from annual income over $1 mill, a capital gain over $1 mill, or even a single filer with income more than $500k. The jury is still out...
- Individual taxes – We expect the next phase of the Biden tax plan will include raising taxes to 39.6% from 37% on taxpayers earning over $400,000.
- Estate taxes – We expect that the administration will propose raising the estate tax rate to 40%, lowering the exemption to $5.5 million from $11.5 million, and ending stepped up in basis at death.
- Real estate taxes – The Biden campaign proposed closing unspecified tax loopholes for real estate. We think this refers to Section 1031 like-kind exchanges.
- Corporate taxes – An outline of the Biden corporate tax plan was already released as part of the American Jobs Plan, which would raise the corporate tax rate from 21% to 28%.
Still, we believe markets may not yet be adequately pricing the impact of higher capital gains, individual, and corporate taxes.
Outlook
As we take a look at our ongoing research thesis of “Seeking investment opportunities in business cycles”, we believe we have shifted from early/mid-cycle to mid-cycle. The mid-cycle is typically the longest phase of the business cycle and displays positive but more moderate growth than the early stage.
Extraordinary expansion of money supply and strong economic growth are powerful forces supporting equity prices. Interest rates moved higher to start the year as economic data was strong, but rates have cooled down to a range of 1.50-1.75% for the US 10-year which justifies current valuations for the market overall, in our view.
As always, both bullish and bearish cases can be made. Some are predicting that as the pandemic recedes, pent up demand and strong consumer balance sheets will translate into a replay of something like the roaring 20’s, featuring abnormally high economic growth and stock returns. We may get to enjoy the benefits of stimulus now without feeling the costs, extreme government debt or the pain of possible inflation until several years down the road.
International stocks are beginning to look interesting as economies slowly start to open in Europe and in general have more attractive prices relative to sales and earnings compared to US equities.
On the other hand, inflation could arrive sooner or stronger than expected, forcing losses in spending power and driving the Fed to raise rates.
If capital gains tax hike is not retroactive, it is likely that there will be a short-term correction, which could be substantial, prior to this date. This is why we believe the capital gains tax hike will be retroactive. Increases to individual capital gains taxes may modestly dampen demand or accelerate selling depending on the timing of such a change. Estate tax changes also have potential to accelerate selling, but neither of these are as impactful to equity prices as corporate rates.
Most importantly, we have not even begun to see the impact of pent up demand in a fully-opened economy. Vaccine doses remain strong and point to an economy fully opening sooner than expected.
While there may be more meaningful risk factors than usual at the moment, it can also be risky to take a defensive stance while rates remain low and the fiscal and monetary stimulus doesn’t show signs of slowing. A major potential of an infrastructure bill is bullish for equities and especially industrials. Cash is usually held for safety, but equities historically provide the greatest insulation from inflation.
Thank you for your interest.
