Important Planning Numbers 2021
May 5, 2021
Issues to Consider in a Quarterly Review Meeting
July 8, 2021
Financial Market Outlook 3Q.2021
The Financial Market Outlook provides a top/down analysis of the U.S. stock market. The objective is to identify those sectors, industries and firms that are most likely to drive stock market performance in 3Q. This article was updated on 05-Aug-2021.
Multi-Asset Returns
The reopening trade dates to November 6, 2020. On that day, Pfizer announced the first successful COVID-19 vaccine. Since then, the best performing asset classes have been commodities, small cap stocks, REITS, mid-cap stocks and the value factor. In summary, the asset classes that performed poorly during lockdown have been winners in the post-vaccine phase.
The Value index (IVE) outperformed growth stocks in 2Q and year-to-date (YTD). The index is dominated by cyclical stocks with stronger earnings growth than tech-heavy growth stocks. This is most evident in the financial sector, which is the biggest component (26.4%) of the Value Index. In 2Q, the financial sector had the largest earnings growth upgrades of any sector. Banks should continue to benefit from further yield-curve steepening and that will also benefit the Value Index going forward.
Interest Rates and World Equity Markets
The long-term consensus is for further yield increases. However, it’s the relative change in yields across countries that will drive relative market performance. For example, the Euro yield curve remains below zero out to 30 years. In contrast, the US yield curve is running 75 to 200 basis points higher. It should be no surprise then that Euro yields are rising faster than U.S. yields, as shown at right. The trend is likely to continue into 3Q. Key drivers include higher vaccination rates in Europe, the European Union recovery fund and delayed expansion when compared to the US.
Rising interest rates point to increased likelihood for solid performance by cyclical, non-technology stocks. For this reason, the market outlook favors increased international stock weightings. Generally, the rest of the world is overweight cyclical value stocks when compared relative to the U.S., which has a higher weight in tech stocks. The difference in market composition should prove material going forward.
Stock market returns for all major developed and developing countries in 2Q.2021 are shown below.
Size and Relative Price Factors in World Markets
The next charts compare the returns for growth versus value stocks, as well as large versus small cap stocks. On a world-wide basis, the dominance of large cap growth stocks continued given low yields in 2Q. However, value stock performance is also evident in small cap stocks in Emerging markets, which had out-sized returns last quarter.
The last piece of the reopening trade to keep in mind is the U.S. dollar. The U.S. Dollar Index (DXY) has traded sideways since the vaccine announcement. It should weaken once investors have fully priced in Fed tightening expectations. The dollar typically gains during global downturns and declines in the recovery phase. Dollar weakness will support performance of non-U.S. markets, notably emerging markets.
U.S. Equity Markets
The U.S. economy is strong — the strongest in nearly 40 years. GDP growth in the first and second quarter came in at 6.3% and 6.5%. GDP estimates for 3Q across 58 broker-dealers range from 5.8% to 8.3% with a median of 7.0%. Similarly, company earnings in the first quarter of the year were among the best ever recorded. S&P 500 earnings growth shattered expectations (52% actual vs. 24% expected). Meanwhile, earnings growth for the second quarter is also coming in higher than expected (90.4% currently vs 52.4% at the end of March).
The breakdown of equity returns for the S&P 1500 by segment appears below for 2Q and YTD:
US Equity Sector Returns
Sector investment returns in 2Q were led by Technology, Real Estate and the Communications Sectors. YTD returns have been led by Energy, Financials and Real Estate, as shown below:
Ultimately, markets are forward looking. The standard business cycle playbook shown below is used to inform expectations for the financial market outlook. For example, YTD returns and the business cycle playbook both confirm we are well into the expansion phase of the business cycle. As a result, the inclination would be to continue to buy cyclical stocks, small stocks and value stocks in 3Q. There is certainly upside potential in value stocks and cyclicals. However, stock selection still requires focus on profitable companies, those with the highest earnings growth and pricing power to pass on inflated supply-chain costs.
Sector Analysts’ Ratings for 3Q
Future earnings expectations are another tool to identify which sectors are most likely to outperform going forward. To this end, analyst ratings (over 10,000 in total) were downloaded from FactSet Research Systems. The ratings were then consolidated by sector and for the market as a whole. The result is an outlook that remains strongly positive. Data for the S&P 500 shows that 56.9% of companies have buy ratings (up from 54% in 2Q). 36.8% of companies have hold ratings. And 6.3% of companies have sell ratings. At the sector level, analysts are most optimistic about Energy (64.1%), Healthcare (63%) and Technology (62.4%). These sectors have the highest number of buy ratings. On the other hand, analysts’ expectations are most pessimistic for Consumer Staples (43.8%), Real Estate (50.0%) and Financials (50.7%). These sectors have the lowest number of buy ratings.
Management Planning and Earnings Insights for 3Q
Management guidance on future earnings can also be consolidated at the sector and market level. The chart below takes management net income estimates for 3Q.2021 and compares them to actual earnings in 3Q.2020 to define year-on-year earnings growth. These growth estimates span all companies in the S&P 500 and are updated with the most recent earnings guidance to calculate how earnings growth is trending, as shown below:
The guidance data is valuable because three essentials conclusions can be drawn:
- The S&P500 is projected to have high earnings growth of 27.9%, up 46.8% since March. The level of earnings growth is moderating as we the expansion phase of the economy matures, but the potential for earnings to exceed estimates remains as the update trend confirms.
- The business expansion phase is still intact regardless of Delta covid. For example, the sectors with the highest changes to earnings growth are those that will benefit most from the expansion phase. Specifically, Financials, Materials, Communications and Real Estate all exhibit the largest changes to earnings growth outlooks going forward.
- It is still too soon to reposition portfolios defensively for slower growth. For example, the data confirms negative earnings growth for those firms that would normally benefit from a transition to an economic slowdown, like Consumer Staples, Healthcare or Utilities.
From Gardens to Bouquets to Flowers
The following tables continue the top/down analysis of the U.S. equity market. The tables look inside each sector of the S&P 500 to identify the industries and firms with the highest changes in earnings growth estimates for 3Q.
Risk Disclosure
The Financial Market Outlook represents my personal views. At the time of this writing, I own the following portfolios or shares mentioned in the report: XLF, XLC, XLE, XLRE, XLB, IVE, IJR, IJW, PSCE, EZU, EDEN, INDA, MCHI, TMUS, JPM, GS, BLK, V, IBKR, CVX, COP, XOM, PVAC, BKR, ENPH, NEE, FCX, NUE, CLF, NET, BSX, ABT, VRTX, LHX, MSFT, NET, NFLX, GLW, WMT, BUD, TAP, SFM, CLX, CVS, LHA,. Prior to publication, this report was shared with private clients from whom I receive compensation. They too may own shares mentioned in this report.
Blog posts are not a solicitation to buy or to sell any securities. Solicitations are only made in person and subject to an advisory contract in place which takes into account the investor’s full spectrum goals, assets, investment policy and tax strategy.
This report does not provide financial planning or tax advice. It is the reader’s responsibility to consult with a financial planner, investment advisor or tax professional before undertaking any investment.
Out of necessity, the report relies on economic surveys, forecasts or projections. Future projections are an important and valid tool for input into investment decisions. However, economic or market projections do not reflect actual knowledge of the future. Future projections, like past performance results, are no guarantee of future investment results or cash flows.
Investments in stocks, bonds, mutual funds, exchange traded funds and other securities may be risky and may be subject to loss of equity or principal.
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