Stock prices, measured by the S&P 500, advanced 2.5% in the month of July, and are now up an impressive 18.1% year to date. Stocks have posted gains in each of the last six months, a sturdy run. According to Bespoke Research, after six-month periods of positive returns, stocks generally continue to advance in the ensuing six- and twelve-month periods of time. Seasonal tendencies can be misleading but are based on actual historical return trends.
Earnings for the second quarter are wrapping up. They have been impressive and there is ample reason to believe they will continue to trend higher. At the start of 2021, analysts projected $175 a share for the S&P 500. That number has since risen to over $200, and the figure for 2022 is $220 a share and rising. This is extraordinary considering the year of the financial crisis, earnings fell to just $50 a share. According to FactSet Research, the blended net profit margin for the S&P 500 in 2Q 2021 is 12.9%, the highest ever reported by the index since tracking began in 2008.
Any good contrarian will point out that stocks are expensive. The forward 12-month PE ratio (a measure of relative price using estimated earnings) for the S&P 500 is 21x; well above its 5 and 10 averages. When stock prices are “high” as they are today, they are referred to as overbought. With the market trending higher, a bullish indicator, this overbought condition can persist. The ratio has ticked down slightly as we are seeing earnings grow faster than stock prices. While the measure may apply to the market as a whole, our effort is to buy individual stocks with attractive relative valuations.
Inflation has been the leading topic of conversation among market watchers for some time now. I do not think inflation will derail the stock market. Inflation is inherent in any growing economy; it is also a hot button. We are seeing increased inflation figures due to the numerous reopening (transitory) pressure points leading to price spikes in used cars, airfare, hotels, transportation, and warehousing and we will also see these normalize. Separately, though not widely acknowledged, one of the best asset classes to navigate the threat of inflation are common stocks.
Patience will be important here, as the labor market slowly gets back on its feet. Fair wages and working from home will be cumbersome for the old guard to step forward and address. Office occupancy rates remain in the 30-40% range. The rate of vaccination (appaling in some areas) is important, as is the gradual re-start of global supply chains. The pandemic is global and far more present in certain communities and countries around the word, causing economic friction. Unfortunately, fewer people are promoting and adopting mask wearing and the recent surge in COVID case counts in the US is concerning.
We ought to expect some increased volatility in stock prices: there has not been significant drop since September 2020 when the S&P 500 dropped over 10%. The issues at hand then related to uncontrolled waves of the pandemic, fears over the upcoming election, and the general state of the economic recovery. Today, the delta variant is looming, fiscal and monetary policy are diminishing as drivers, and there is an obsession relating to Federal Reserve policy and inflation. The point is, the market has been complacent, and that’s often worth heeding.
In my opinion, interest rates will remain low for some time, with the Federal Reserve well aware of the challenges the economy faces. Focus remains on quality growth stocks – ones that can bring above-market growth, earnings, and continued innovation to the table in what may be a continuation of a declining growth and lower inflation marketplace. I also think there is an extended trade in reopening stocks, which will benefit the most from the eventual normalization of the global economy. We are putting more emphasis on stocks with longer term sustainability and ESG criteria.
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Bruce Hotaling, CFA
The views and opinions stated herein are those of Bruce Hotaling, are of this date, and are subject to change without notice. Information contained in this report was received from sources believed to be reliable, but accuracy is not guaranteed. Investments are subject to market risk, including the possibility of loss of principal. Past performance does not guarantee future results. The S & P500 is an unmanaged index of 500 widely held stocks. Investors cannot invest directly in an index. The PE ratio (price/earnings) is a common measure of relative stock valuation.