In observance of the one-year anniversary of the coronavirus crash low, we would like to reflect on what an impressive year it has been. The 74.9% return from March 24, 2020 – March 23, 2021 was the largest one-year return since World War II. The returns experienced during the past 12 months are likely to be of a magnitude very few current investors, if any, will ever experience again. Given such a landmark year, we wish to use this month’s commentary to discuss the current state of affairs and what may be in store for the market based on historical templates.
Market Strength is at a Decade High
Overall, the market remains extremely strong, of course, with the S&P crossing 4000 for the first time in history. The pervasive strength we have referenced over the last few months remains, with strength across different sectors, styles, capitalizations, and geographies. We are seeing a widespread global reflation due to a combination of virus optimism, loose monetary policy, and, in some cases, aggressive fiscal policy. Breadth Indicators not only remain strong but are getting stronger. Over 95% of the S&P is in an uptrend (defined as being above respective 200-day moving averages), the largest percentage since late 2009. These extraordinary levels of market strength often beget selloffs or corrections in the market, but these drawdowns end up being not much more than pit stops on the market’s way to achieving new highs down the road. Conversely, major tops occur not during periods of strong market breadth but rather during periods when the markets are rising the strength of fewer stocks.
Although the U.S. dollar has been in a general downtrend during the last year, it has strengthened a bit in 2021 (up ~4% year-to-date), a rise that looks more like a countertrend than a newly-developed trend. And, despite the strength of the U.S dollar, Emerging Markets have continued to post strong results (up ~3% year-to-date), which is usually not the case; a stronger dollar is generally an albatross on Emerging Markets asset prices. Similarly, as interest rates have risen over the last eight months, we are seeing strength in areas generally tied to falling interest rates, most notably homebuilders, who are finally breaking above highs set over 15 years ago, in the buildup to the housing bust and Global Financial Crisis. So, the fact that market areas are continuing to fire on all cylinders, even in the face of conditions that typically serve as headwinds, is another testament to the current strength in markets.
Inflation, Commodities, and Credit Signal Continued Strength
Speaking of rising interest rates- so much for all the handwringing and fearmongering about the death of the bull market on the sharp rise in interest rates! All we have seen in the aftermath of the supposed inflation-fearing temper tantrum from the bond market is new high upon new high. It bears reiterating that rising bond yields are generally bullish, not bearish. As we state in our recent inflation blog :
“This inflation is not of the pernicious variety that triggers fear in many who lived through the late 1970s, but rather a normal reversal of the deflationary pressures felt late in the preceding contraction, which the U.S. economy experienced in the middle of 2020. Bond rates follow suit in moving higher as the economy expands; where the bond market gets concerned is when the economy is encountering inflation and overheating many years into an expansion, which is clearly not the case this time given a recession that is only several months in the rearview mirror.”
In other words, if rates are too low, it is also problematic, which is often the case in the throes of recession and economic turmoil.
The initial rise in rates, which reverses rates from being “too low” is a sign that the economy is indeed returning to health as strong as the equity markets have been saying in advance of the interest rate rise.
Even after the strong run, there are many signs that the market remains strong. The S&P crossed 4000 for first time on April 1 with commodities rising (most notably copper and oil), the consumer discretionary sector sharply outperforming the consumer staples sector, and credit spreads remaining relatively low. To that last point, we always look to credit as our number one canary in the coal mine for potential weakness in the equity markets; credit right now is saying that any global virus worries are more a health concern and less a financial concern.
History Suggests Challenges in Second Year off Rock Bottom
Having said all that, the most important takeaway reiterates what we said last month – the easy money that is made in year one off a major low becomes a much more challenging task in year two. Expanding on our point last month, below is a chart of the ten highest S&P 500 one-year returns since World War II:
Figure 1. Ten highest one-year returns of the S&P 500
Source: FactSet and Balentine
As seen in the chart, returns over the three-month and six-month periods after the market passes the one-year mark are random at best and a garden-variety drawdown at worst. But note that by the end of the second twelve months, the year has typically fared well for equities. So, if the historical template holds, it would not be surprising to see a challenging grind through the summer and into early fall and then a resumption higher.
So, what sets the stage for a move higher after a slog with perhaps a non-trivial drawdown? Historically, it has been a stronger-than-expected economic recovery. Examples include:
1950/1951: Real GDP exceeds 8%. The market corrects 14% in 1950 and another 8% before climbing higher.
1955: Real GDP exceeds 7% while the market endures a modest 11% correction before moving higher.
1984: Real GDP exceeds 7%, but the market churns in place as it digests the huge move off the 1982 lows. A correction of 14% in the first half of 1984 gives way to a major reacceleration later in the summer and into 1985.
So, in year one, the market has epic years while the economy is still reeling, then in year two, the market struggles to find direction while the economy is performing extremely well. What exactly is going on here? In our 2019 Capital Markets Forecast and our 2021 Capital Markets Forecast we wrote:
2019: “Capital markets usually move in advance of the economy, not the other way around.”
2021: “Think of the relationship between the economy and the stock market as similar to the relationship between a boat and a skier being pulled by that boat: they will, over the longer term, trend in the same direction and will be tethered to each other. But over any short-term period, they can be moving in different directions, in different magnitudes, and at different velocities.”
Combining these two ideas, we see that at large turning points, the market tends to move ahead of the economy, but the market must pause and figure out some direction while the economy catches up, thus bringing valuations more in line with historical averages.
Setting the Stage for a Bull Market
Applying this to today’s situation, it was not but a year ago that a low-40 PMI (Purchasing Managers’ Index) posting was leading to 2020 GDP forecasts of Armageddon, and the market was pricing in a thoroughly nasty recession (and perhaps worse). Race forward a year, and we are seeing mid-60s PMIs and strong payroll numbers as hiring resumes. The market has raced ahead in anticipation of this, and we now wait patiently to let the market digest the expected economic rebound. The recent PMI reading was the strongest since 1984, which makes for an interesting comparison given the aforementioned 1984 equity market action and the comparable market strength in the preceding year. So, in summary, it would not surprise us to see much of 2021 turn into an up-and-down grind while the real economy catches up, setting the stage for the next leg of the bull market to commence.