Strong Earnings Growth Is Expected... And Crucial To Justifying Equity Valuations

After a strong Q1, stocks continue to rise on exuberant optimism, and the mega-cap dominated S&P 500 and Nasdaq 100 just hit new highs this week. Notably, the Tech sector significantly lagged the broader market during the second half of Q1, primarily due to worries about the apparent spike in inflation and a surge in the 10-year Treasury yield (as a higher discount rate on future earnings has greater implications for longer duration growth stocks). But once the rapid rise in yield leveled off, Tech caught a bid once again. The Russell 2000 small-cap index, after absolutely crushing all others from November through mid-March, has been cooling its jets for the past several weeks. I think the other indexes will need to do the same. In the short term, after going straight up over the past two weeks, the S&P 500 and Nasdaq 100 both look like they need to pause for some technical consolidation, but longer-term look pretty darn good for solid upside – so long as earnings reports surprise solidly higher than the already strong predictions, and Q1 earnings season is now at hand.

Regular readers know I have been opining extensively about the bullish convergence of positive events including rapid vaccine rollout, reopening of the economy, massive fiscal and monetary stimulus/support, infrastructure spending, pent-up demand, strong revenue and earnings growth, and the start of a powerful and sustained recovery/expansionary economic phase – but with only a gradual rise in inflation and interest rates – in contrast with those who see the recent surge in inflation metrics and interest rates as the start of a continued escalation and perhaps impending disaster. Notably, in his annual letter to shareholders, JPMorgan CEO Jamie Dimon laid out a similar vision, referring to it as a “Goldilocks moment” leading to an economic boom that “could easily run into 2023.”

In my view, it was normal (and healthy) to see record low-interest rates last summer given the economic shutdowns, and as the economy begins to reopen, interest rates are simply returning to pre-pandemic levels. Furthermore, relatively higher yields in the US attract global capital, and the Fed continues to pledge its support – indeed, I think it may even implement yield curve control (YCC) to help keep longer-term rates in check.

And as for inflation, the March CPI reading of 2.6% YOY sounds ominous, but it is mostly due to a low base period, i.e., falling prices at the depth of the pandemic selloff in March 2020, and this dynamic surely will continue over the coming months. Although we see pockets of inflation where there are production bottlenecks (e.g., from shutdowns or disrupted supply chains), it seems that massive stimulus has created asset inflation but little impact on aggregate demand and consumer prices, as personal savings rates remain high and the recent stimulus programs have mainly gone to paying bills, putting people back to work, and building up personal investment accounts. Future spending bills targeting infrastructure or green energy might have a greater impact, but for now, the huge supply of money in circulation is largely offset by disinflationary drivers like low velocity of money, aging demographics, re-globalization of trade, and supply chains, and technological disruption. The Treasury market seems to be acknowledging this, as the rapid rise in the 10-year yield has leveled off at around 1.7%.

Thus, I believe that growth stocks, and in particular the Technology sector, must remain a part of every portfolio, even in this nascent expansionary economic phase that should be highly favorable to value and cyclical sectors like Industrial, Financial, Materials, and Energy. Put simply, new technologies from these Tech companies can facilitate other companies from all sectors to be more efficient, productive, and competitive. However, investors must be selective with those secular growth favorites that sport high P/E multiples as they likely will need to “grow into” their current valuations through old-fashioned earnings growth rather than through further multiple expansion, which may limit their upside.

And with Sabrient’s enhanced selection process, we believe our portfolios – including the Q1 2021 Baker’s Dozen that launched on 1/20/21, Small Cap Growth portfolio that launched on 3/15/21, Sabrient Dividend portfolio that launched on 3/19/21, and the upcoming Q2 2021 Baker’s Dozen that launches next week on 4/20/21 – are positioned for any growth scenario.

In this periodic update, I provide a comprehensive market commentary, offer my technical analysis of the S&P 500 chart, review Sabrient’s latest fundamentals-based SectorCast quant rankings of the ten US business sectors, and serve up some actionable ETF trading ideas. To summarize, our outlook is bullish (but with occasional bouts of volatility), our sector rankings reflect a solidly bullish bias, the technical picture is still long-term bullish (although in need of some near-term consolidation), and our sector rotation model retains its bullish posture.  Read on….

Commentary:

The S&P 500 (SPY) was up +6.2% during Q1, while its equal weight counterpart (RSP) nearly doubled it at +11.5%, which illustrates the greater market breadth and leadership from smaller names. But so far in April, growth stocks and mega-caps have resurged, allowing SPY to outperform RSP. While rising rates tend to hinder the appeal of Tech stocks, banks and insurance companies tend to benefit, and indeed the Financial sector saw the most institutional buying during Q1. The top-performing sectors were deep cyclicals Energy, Financial, Industrial, and Basic Materials, while the worst performers were Consumer Staples, Info Tech, and Utilities, although Utilities and Staples came on quite strong during March in concert with dividend strategies in general. According to S&P Global, the top factor strategies for the S&P 500 during Q1 were High Beta (+22.7%) and Pure Value (+21.0%), while Momentum (+0.2%) and Pure Growth (+0.8%) were the worst performers. Notably, it was the Value factor’s largest quarterly outperformance versus Growth in 20 years.

The chart below illustrates the performance differentials by comparing Invesco S&P SmallCap 600 Pure Value (RZV), iShares Russell 2000 (IWM), and iShares Micro-Cap (IWC) versus the Invesco S&P 500 Pure Growth (RPG), Invesco Nasdaq 100 (QQQ), and the SPY since the value rotation began on 11/1/2020. You can see that the growth and large-cap oriented SPY, QQQ, and RPG are bunched together at the bottom and have lagged badly but have outperformed so far in April. At the top are small-cap value and micro caps.

Performance comparisons

Furthermore, in comparing factor-based strategies for the S&P 500, the High Beta factor has greatly outperformed all other factor-based strategies over the past 12 months since the start of the pandemic selloff recovery, followed by Pure Value. Also, Barclays pointed to a basket of high-debt stocks as the best performer YTD, while a basket of high-profitability stocks is the worst-performing. Although it seems reminiscent of the 1998-9 dot-com bubble, in this case, many of these highly leveraged firms are expected to thrive during the “reopening trade.”

This all serves to illustrate the risk-on market rotation that began in mid-May 2020 – and has surged since 11/1/2020 – favoring mid, small, and micro caps, the high-beta and value factors, and cyclical sectors. This euphemistically has been termed a “junk rally” given that many of these companies have not yet reported great numbers in their filings but are rallying in anticipation of a bullish convergence of positive events. No doubt, massive global fiscal and monetary stimulus/support has been crucial. In fact, the International Monetary Fund (IMF) estimates that without this government support during the pandemic, the global recession would have been 3x worse – but instead, the COVID recession likely will have less lasting impact than the Great Financial Crisis (GFC) in 2008.

Recall that to address the GFC, Fed policy primarily served to recapitalize banks rather than to juice the economy. Without additional lending, the recovery was sluggish (a “plow horse economy,” as Brian Wesbury of First Trust has called it), so value stocks struggled while less capital- or labor-intensive growth companies thrived due to an ability to maximize productivity in the "jobless recovery.” This time, however, banks were already healthy, and stimulus has been specifically targeted at boosting economic activity.

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Disclosure: Author has no positions in stocks or ETFs mentioned.

 

Disclaimer: This newsletter is published solely for informational purposes and is not to be construed as advice ...

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