One year into the equity bull market!

“Straight roads do not make skillful drivers.”

– Paulo Coelho, The Alchemist

It’s been quite a year! This time last year, the S&P 500 was hitting a trough, down 35% from its peak on February 19. The world was only beginning to understand the COVID-19 virus and many thought the virus would only impact our lives for a short period of time. The bad news, of course, is that we’re still dealing with the virus as a society and are likely to be dealing with the after-effects for some time. The good news is that we’ve developed effective therapeutics along with many effective vaccines that are in the early stages of rollouts around the world, giving hope that we’ve turned the corner in this health crisis.

From an investment perspective, the good news is that the S&P 500 Index is up 78%, on a total return basis, from its low on March 23, 2020. The equity market suffered both its fastest bear market and one of its fastest recoveries in history. The March 23 low coincided with an announcement by the Federal Open Market Committee (FOMC) that they were essentially “all-in,” from a monetary policy perspective, to support the economy with unlimited asset purchases and ultra-low, short-term interest rates. We now know that this was the beginning of the bull market.

The reflationary period of an economic cycle is typically the period immediately following the bottoming of the recession. It’s defined as expansion in the level of an economy’s output by government stimulus, using either fiscal or monetary policy. While some may lament that the reflation trade in the equity markets may be over, given the recent and rapid increases in commodity prices, stock markets, and long-term bond yields, we argue that the economic reflation has only just begun. We believe that long bonds and equity markets reflect the normalisation phase of the economic recovery and have more room to move higher.

When analyzing the market environment, one of the first things our team looks at is the risk of recession, as this is often the main catalyst to a prolonged market downturn. When reviewing the fundamental data, there are no signs of a risk of a double-dip recession.

While some data such as the ISM Manufacturing Purchasing Managers’ Index (PMI) may be peaking and could start to roll over, we believe there’s little fear of an economic stall-out given the still massive amounts of fiscal and monetary stimulus that need to work their way through the U.S. and global economies.

ISM Purchasing Manager Index
Last 20 years

When examining PMI, we must remember this is a relative index that measures the change in various inputs on a monthly basis. Even if we were to see the index value roll over and begin to decline from current levels over the next few months, this would simply imply that the month-over-month change (or delta) is slowing rather than moving negative. It’s also important to look at some of the underlying aspects of manufacturing — such as backlog of orders, new orders, and inventory — to see what’s driving the direction of the overall index level.

The backlog of orders index registered 64 percent in February 2021 — an increase of 4.3 percentage points from January — and is its highest level in the history of the PMI.

ISM Manufacturing Report on Business Backlog of Orders
Last 20 years

This high reading of backlogs shouldn’t be surprising considering the supply chain disruptions that have occurred as a result of pandemic-induced lockdowns over the past year, China-U.S. trade tensions, and more recently, weather issues in Texas and clogged ports in California. The backlogs cover many goods, from lumber to semiconductors and just about everything in-between. For example, the shortage in semiconductors is forcing some companies such as Toyota, Honda, and Samsung to halt production at some plants.

Federal Reserve Chairman Jerome Powell said at a press conference Wednesday that he expects supply chains to adjust as economic growth accelerates: “… it’s very possible, let’s put it that way, that you will see bottlenecks emerge and then clear over time. … these are not permanent. It’s not like the supply side will be unable to adapt to these things. The market will clear. It just may take some time.”

We believe what could further complicate supply chain disruptions is a strong increase in demand as consumers emerge from lockdown with excess savings and a desire to spend. According to the Bureau of Economic Analysis, Americans have 250% more in savings as a percentage of disposable income vs January 2020. The Total Business: Inventories to Sales Ratio, as measured by the Federal Reserve Bank of St. Louis, is near its all-time low, last reached in 2011. This low ratio should lead to continued elevated levels of manufacturing, an improved economic environment, and stronger earnings growth.

Total Business: Inventories to Sales Ratio (Seasonally Adjusted)
1992 - Current

Nothing has changed from our “rapid reopen” thesis that we wrote about in our 2021 outlook. We wrote that “we must remain focused — forward-looking — not on the risks that may arise in the near-term as we transition from an environment where COVID-19 continues to rage, but to an environment 12 months from now where more of the global population is protected against COVID and we enter an environment that we call the rapid reopen.”

As the bull market turns a year old, we may be hitting peak valuations and beginning the transition to earnings growth as the driver of equity market returns.

Our team often uses the quote from Mark twain, “History doesn’t repeat itself, but it often rhymes.” While the path to recovery may appear different, the destination is the same. Given the solid economic environment, we caution investors against any knee-jerk reactions to market movements and would embrace any short-term pullbacks as an opportunity, not a threat.

Kevin Headland, CIM
Senior Investment Strategist