Though secular bull markets tend to be long in duration (average of 5 years since 1930 as shown in table below), it is inevitable that investor conviction wavers during the course of this journey. We have highlighted previously the historical tendency of the second year of a bull market to be both less rewarding and more volatile as compared to the initial year (table below).
Source: Bloomberg Finance
The current market advance is closely following the historical script. In the first year of a market advance stock prices are bid up well before earnings have started to recover. That is to say, market valuation rises significantly on the expectations of recovery. By the second year, investor focus shifts purely from leading indicators of recovery to the actual trajectory of earnings themselves. It is during this period that earnings growth outstrips the market advance and valuation multiples contract, limiting the market advance. The chart below shows how the European market has followed this playbook to perfection. Index valuation multiples have been in decline since Q4 of last year (white line) as earnings growth has been faster than the market advance itself (blue line).
Source: Bloomberg Finance
As the recovery strengthens, investors start to question the sustainability of the stimulus measures that have usually been put in place during the period of the market collapse. Market rotation is common as investor alter their bets based on reactions to the most recent incoming data. Current evidence of this rotation may be gleaned from the graph below showing the market cap weight US index versus an equally weighted index (all companies have same weight). While the equally weighted index remains at the levels reached in May, the market cap weighted index has made numerous new highs through June and into July. Investor flows have switched to the mega-cap constituents at the expense of the smaller companies in the index.
Source: Bloomberg Finance
This equity market rotation combined with declining global long-term bond yields has led to a growing concern that the reflation trade is over, and the best of the recovery is now behind us. We think the market is putting too much weight on scenarios where the economy is unable to handle even a modest degree of policy tightening or a temporary setback due to a policy response to the current rise in global covid cases. While economically sensitive sectors have suffered losses during the past 6 weeks, this should be put into context. The chart below highlights the returns in the Materials sector from the market bottom in March 2020. The negative return since mid-May has come against a backdrop of a rising index but should also be put into the context of the significant prior return. As stated in previous updates, we continue to see the recent pull-back in the reflation trade as a healthy correction in a continuing uptrend as opposed to an early warning of rapidly slowing economy.
Source: Strategas Research Partners
Concerns over peak growth should also be placed in context. Much is being made that Q2 earnings growth in the U.S. at +60% will mark the year-on-year growth peak (blue bars in chart below). Less acknowledged is the rapid recovery of earnings even compared to the peak levels of 2019. Compared to peak 2019 levels, quarterly earnings momentum will actually be accelerating into year-end (red bars). The outlook for corporate profitability remains robust and should provide stock support.
Source: Strategas Research Partners
On the macro-economic front, although the US ISM peaked in March, one can argue that this was more of a technical peak than a business cycle one: the sudden reopening of the economy has by nature generated a rapid growth acceleration, which was necessarily going to slow. The US ISM remains above 60, European PMIs continue to reach record highs, and corporate profits in both the US and Europe will be above their pre-Covid levels at the end of 2022 – nothing to suggest the beginning of a secular stagnation scenario.
The recent decline in bond yields has sent the real rate (adjusted for inflation) to new lows for this cycle. It would be unprecedented for either a recessionary scenario or major market collapse to start with real rates at such low levels. Given this macro backdrop, the recent setback in reflationary areas has likely created investment opportunities.
Source: Strategas Research Partners
