Stocks rally on good earnings news, but storm clouds loom

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Shipping to Downtown Brooklyn, New York A booming US economy will be a continuous tailwind for income.

Spencer Platt / Getty Images

the

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 321.61 points higher at 34,529.45, up 0.94%. the

S&P 500 Index

gained 1.16%, to 4,204.11, while the

Nasdaq Composite

increased 2.06% to 13,748.74.

The path of least resistance for the market remains higher, and while investors can point to many storm clouds on the horizon, they appear to be problematic for another day.

“If you only look at the traditional valuation indicators, they are broad from history and it’s easy to fall between cautious and bearish,” says 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 forecast earnings are up about 40%, according to Credit Suisse 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 U.S. economy will be a continued tailwind for revenues – just look at last week’s retailer results – while much of the pandemic’s cost cuts for businesses remain in place, increasing prices. 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 at 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 higher interest rates and 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.

The Wall Street consensus is that the 10-year Treasury note is earning 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 sitting on top of good news already being cut, but peak bad news is not yet factored in, and we’re entering a slower time of year when people go on vacation and people go on vacation. trade volumes are decreasing “, states Robert phipps, director at Per Stirling Capital Management. “It wouldn’t surprise me if the market detaches for a while.”

The solution may be to focus on stocks and sectors that can benefit from tailwinds as a whole while remaining relatively isolated from headwinds.

This drives investors to the more cyclical and value-oriented areas 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 there is potential for the trade to continue to function.

“Historically, the

Russell 1000 Growth

trades at a multiple points premium of 5.6x over value, ”Golub writes. “It is currently trading 10.3x above.” Every point of the valuation spread that narrows 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 relatively insulated software and tech sectors against a pandemic, who face more difficult comparisons.

The market will not always be as calm as the past two weeks. Consider overweighting Industrials, Banks, Materials and Energy, and expect a better entry point for expensive long-term growth names.

Write to Nicholas Jasinski at [email protected]

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