We mentioned in last month’s blog that “as has been the case with this bull market, any time we have some turbulence, investors begin to get concerned about 'the big one.'" We are here to tell you that the bumpiness in late January has all the hallmarks of a typical pullback in a bull market, based on historical precedent. Of course, history could be ‘different this time,’ but it is rarely wise to position’s one portfolio that way.”
Right on cue, equities put up another solid month (ACWI +2.4%). But what made the month even more impressive was how stocks performed in comparison with bonds. ACWI outperformed the Barclays U.S. Aggregate Bond Index by 380 bps in February, with the weakness in bond prices a result of the sharp rise in yields during the month.
Digging even more deeply into the weakness in bond prices:
The domestic bond index had its worst performing month in over four years, since November 2016;
Combining January’s and February’s decreases, bonds had the greatest two-month decline since this equity bull market began, a decline last surpassed at the onset of the 2003-2007 bull market &
Globally, the effect was even larger, as global yields rocketed even higher than they did domestically. The Barclays Global Aggregate Bond Index posted its largest decline in over 12 years, last dropping this much in January 2009, at the tail end of the Global Financial Crisis (GFC) bear market.
So, what do we make of these moves in interest rates, and what does it mean going forward? With “inflation scares” all the rage these days on the back of pervasive and overbearing reports of the Federal Reserve “printing money,” the consensus idea is that rates are rising in anticipation of imminent inflation. And lest the bond market be the only market at the inflation party, it seems as if equities have followed suit, with inflation-sensitive stocks such as financials, energy, and materials rocketing higher while equities more levered to deflation (e.g., technology) are getting thrashed.
We do not believe this is the message of the bond market or the stock market. Rather than being about looming inflation, we believe yield rises are, quite simply, more about the economy improving. As economic cycles unfold, markets go from a deflationary mindset to a disinflationary mindset to an inflationary mindset, and then all the way back again. The move from a deflationary mindset to a disinflationary mindset, without concerns about an overly inflationary environment looming, has historically shocked the market in a magnitude similar to when an inflationary mindset takes hold. We saw this in early 2003 and 2009, as referenced in the aforementioned bond statistics. And, in fact, after deep bottoms, rising rates has typically been good for stocks.
There is an important point here. Now that the worst of the pandemic is seemingly behind us and the economy seems to be on the way to a “V” rebound, it is easy to forget that a year ago, fear was as pervasive as was seen at the climax of the GFC. This level of fear is seen normally at the climax of bearish moves as well as in anticipation of an economic bottom in the near term and a subsequent rebound. Recall in our blog posts from March 20, April 03, and April 08 last year, where we compared the COVID-induced crash with what we saw in prior market bottoms. Below is an update, looking at 1982 and 2009 (Figure 1). Note how similar the first year was – very strong returns. Importantly, year two differed – flat for a while, tough drawdown. In the case of 2009, this lasted only about seven months, whereas the 1982 episode lasted longer (Figure 2).
The crucial takeaway here is that the easy money off the bottom has been made and now it gets tougher. Significantly, this is not fatal for the market, but it does mean that investors need to adjust expectations accordingly to the idea that while year two off the bottom can still be fruitful, it likely will not be as fruitful as year one.
Figure 1. Year One Off a Deep Bottom is Generally Very Strong…
Source: FactSet and Balentine
Figure 2. …Whereas Year Two is More Challenging.
Source: FactSet and Balentine
Our confidence that year two will be bullish stems from a combination of the following factors:
No expectations of the Fed coming off things monetarily;
Tremendous fiscal spending so far ($1.9 trillion just passed and the potential for $2.0 trillion in infrastructure later) &
The new vaccine remains bullish (to date, 20% of adult population has been vaccinated and expectations are that all people wishing to be vaccinated will be done by the end of May).
Much of this has been priced into the market at current valuation levels, however we believe the forthcoming earnings rebound will make up for the likely lack of valuation expansion moving forward. Recall that the Shiller Cyclically Adjusted P/E (CAPE) ratio first crossed 30x during the 90s bull market in June 1997, but the bull went on for almost three more years. For some context on the CAPE ratio, prior to the internet bubble, the ratio had passed 30x in only two months (September and October 1929), in advance of the Black Monday crash that heralded the Great Depression). Yet it remained above that threshold for over four years, well into the bear market that began in 2000.
So, just because stocks are expensive does not mean they cannot remain so; more importantly, stocks can get less expensive as they continue to rise so long as earnings growth outpaces the growth in stock prices, which very well may be the case here as strong earnings growth is forecasted.
In summary, we continue to believe a secular bull market is underway, and our models are affirming as such. There will be some weakness in the markets, as year two is generally bumpier than year one, but it is important to fight the temptation to get too bearish. This is different than the late 90s, where participation was thinning, and the economic breadth is more widespread right now.