With 5 months of 2021 in the books, the steady ascent of the S&P 500 has been nothing short of remarkable. The index is up over 13% on the year and has yet to have a drawdown of 5% or more. The early months of 21 were characterized by a relentless pursuit of reopening and unprecedented stimulus. Markets surged higher in anticipation of both. Following the passage of the 3rd round of stimulus in March and a dramatic change in the trajectory of COVID-19, markets have grown increasingly reflective. Since the start of April, the S&P 500 has only added 4% and has largely moved sideways for the last 6 weeks. Participants are now starting to show concern for the long-term effects of a massive increase in the money supply and a stubbornly high unemployment rate. These concerns are centered around rising prices for consumers and higher input costs for businesses. Inflation is beginning to drain the punch bowl filled to the brim by a generous Fed and Treasury Department. Gains from this point will only get tougher and will largely be dependent upon the trajectory for earnings.
Historically, there is a negative correlation between inflation and "growth" stock returns. This is because the bulk of a "growth" stock's value is derived from the earnings we can expect in the future. As inflation rises, these future earnings must be discounted at a higher rate to account for diminished purchasing power in the future. To that end, "growth" stocks continue to underperform their "value" counterparts, where a greater portion of the value is derived from present earnings. These value companies are often more cyclical and benefit from the more immediate rise in earnings expected to come because of the reopening and pent-up demand. So, while the tech-heavy S&P 500 has lagged, more cyclical corners of the market have continued to impress. The question is: for how long?
The Fed's preferred measure of inflation, Core PCE, came in at 3.1% for the month of April. This was higher than economists had expected. Still, the Fed remains in the camp that inflation is transitory. In their view, it is coming from a low base, and any supply/demand imbalances will work themselves out as the economy gets back to normal. Yet, there is a growing sense that this could be shortsighted, especially in the face of rising wages. With job openings at a record despite an unemployment rate of over 6%, companies have been forced to increase wages. Higher wages could result in stickier inflation than what the Fed anticipates. Should that be the case, they could be forced to tighten faster than their current timetable indicates. At that point, the growth/value dynamic could turn once again.
For now, the market really has no choice but to wait and see what happens with inflation. The drift of the last few weeks makes sense with this kind of backdrop. In a sense, investors have really pushed profit-to-earnings ratios (P/Es) as far as they feel comfortable. With multiples stretched to the limit, it is now up to earnings to take the ball. Companies delivered stellar earnings reports in the 1st quarter, and expectations for this year and next have only gotten stronger. Stocks can continue to move higher without further P/E expansion, but we must see companies continue to deliver on their fundamentals. We'll be keeping an eye out for those who stand out.
Preston May, CBE®
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