As most investors know, equity markets continued to achieve record highs during the first quarter of 2021. The story of the second quarter is still unfolding, as it is impacted by economic reopening amid the vaccine rollout, as well as concerns of rising interest rates and the prospects for inflation. While U.S. stocks have fared well so far, bonds have declined amid the rise in rates. Below is an overview of the equity markets so far this year. Next month we will look a little closer at bonds.
As shown in the table below, the S&P 500 was up about 6.2% in the first quarter of the year, following an incredibly strong 2020 performance off the Covid-19 lows. The speed at which the correction occurred last year was striking, as is the recovery that has since followed. It has left many wondering about the health of the market, both in terms of valuations and the potential to be “overdone” and disconnected from the real economy.
U.S. stock valuations remain high by historical standards, although less so when the top few stocks are excluded from the calculation. The Price-to-Earnings ratio (“PE Ratio”) on the S&P 500 stood at about 22x at the end of the first quarter. Diving deeper, though, we see that the ten largest S&P 500 stocks are trading closer to 32x earnings, whereas the remaining 490 stocks in the index are trading at less than 20x (Source: JP Morgan). Valuations should also be viewed in the context of the low but rising interest rate environment currently in place that, as discussed below, makes bonds less attractive by comparison.
As optimism about economic reopening increased, the market also saw a shift in favored market segments. Per a recent Schwab commentary: “The chart below shows two Goldman Sachs-created indexes: “stay at home” stocks (those that are seen as beneficiaries of consumers spending more time and money at home) and “re-opening” stocks (those likely to benefit from consumers spending less time/money at home). Again, the timing of the pickup in relative performance by the re-opening stocks was also pinned to early November; with the latest moves bringing the “re-opening” cohort comfortably above the “stay at home” cohort.”
The recent rise in interest rates undoubtedly played a role in this gap closing as well. When rates rise, the discount rate that the market uses to value high-flier stocks increases, thus those stocks often underperform in such periods. That has been evident in specific names and more broadly when comparing market segments (Value stocks have outperformed Growth/Tech stocks in recent months). This is another good reminder of the importance of a disciplined and diversified investment approach; investor preferences will ebb and flow, particularly through this cycle of economic reopening amidst a dynamic interest rate environment.
Overall, we continue to be optimistic about the general path of the U.S. stock market. Further, we are mindful of constructing portfolios in a way that allows our clients to capitalize on a variety of market themes. We believe that our strategic allocations toward the Value and Small Cap segments of the market should see continued outperformance in the near term. These segments of the market are well aligned with the dynamics of economic reopening and are poised to play “catch up” after lagging Large Cap and Growth in recent years. Nonetheless, our strategic allocations toward Growth and Large Cap stocks remain an important component of an investor’s portfolio. As a result of the pandemic environment accelerating adoptions of a number of important themes (e.g., remote working, automation, AI, etc.), innovation and technology should continue to be key drivers of the future. Within the context of our managed strategies, we will always be highly diversified and are prepared to make tactical adjustments to portfolio positions as market conditions evolve.
There are good reasons to be optimistic about foreign stocks in the coming years, as well. Global valuations look compelling, particularly compared to their US counterparts, with global stocks trading at around 17.5x earnings versus a 25-year average of about 20.4x earnings. Further, as illustrated in the chart below, corporate earnings growth in foreign markets is expected to rebound sharply after a dismal year of pandemic-impaired earnings in 2020.
Additionally, it might simply be time for foreign stocks to close the gap a bit versus U.S. stocks. The degree of U.S. outperformance in recent years, as shown in the graph below, is notable, and these trends don’t last forever.
While our investment strategies will almost certainly favor U.S. over foreign and emerging markets in absolute terms, we are mindful of these trends and actively consider the mix of U.S. vs. non-U.S. stocks within our managed strategies.
Eric Toole, MBA, CFP(R), is a Principal at Antares Wealth Management. He can be reached at firstname.lastname@example.org.