After a nearly 90% rally off the March 2020 lows, it is not a surprise that since mid-April the S&P 500 Index has been choppy and has generally moved sideways. Consider that the 1982 and 2009 bull markets both suffered from some fatigue several months into their second years, providing a useful historical comparison. With the U.S. economy picking up speed as the end of the pandemic likely approaches, the economic cycle is maturing. The pickup in inflation and related concerns about the Federal Reserve (Fed) pulling back support offer evidence of an economic cycle getting a bit older. Older cycles tend to bring more moderate stock market gains.
Although no one would argue that this cycle looks like any other we have experienced in modern history, studying the second year of historical bull markets can be instructive. Looking back at all the bull markets since 1950, the average S&P 500 gain during the second year has been about 13%. With stocks already up about 13% this year, there is not much room for a lot of upside should the market follow precedent. However, when focusing on bull markets that followed 30% or greater declines, as the current one did, the average gain during the second year has been 17%.
One can also look at pullbacks (5-10% decline) and corrections (10-20% decline) during the second years of historical bull markets for a guide to the type of volatility the stock market might experience over the next six to nine months. The average maximum drawdown for the index during those years has been about 10%. In the second year of the 2009 bull market, the index corrected about 17%. Given the fast pace of the reopening and the amount of stimulus spending still working its way through the economy, we would expect drawdowns to be average, if not less, as the bull market moves closer to its third birthday on March 23, 2022.
Inflation that proves more intense and longer lasting than the Fed expects, which could drive interest rates sharply higher, ranks at the top of potential causes of a correction in the second half of 2021 or early in 2022.
Coming off a stunning first-quarter earnings season that saw results well ahead of the best-case scenario for nearly all strategists, corporate America is firing on all cylinders. Not only are earnings expected to ramp up significantly over the remainder of 2021 as the economic rebound continues, but estimates have risen significantly since the start of the year.
A significant pickup in inflation could present risk to corporate profit margins. If the labor market tightens in a fully reopened economy, companies may see upward pressure on wages. Supply shortages, higher commodity prices, and rising borrowing costs may also erode profitability of U.S. companies. U.S. businesses are also closely monitoring policy developments, as a potential increase in the corporate tax rate would have an immediate impact on their bottom lines. Meanwhile, some international economies are still struggling to get through the pandemic, which could present a headwind for U.S.-based multinationals.
Strong earnings growth is helping stocks grow into elevated valuations. However, based on the most used valuation metrics such as the price-to-earnings ratio (P/E), stock market valuations are still elevated. The S&P 500 Index is trading at a forward P/E of 21 times the consensus earnings estimate for the next 12 months, several points above the post-1980 average of 17 (source: FactSet). By that measure, a lot of good news is priced in.
We expect additional gains for stocks in the second half of the year, but they are likely to be more modest than the gains seen so far, and those additional gains are likely to come with more volatility. Amid a backdrop of an improving economy, massive levels of fiscal and monetary stimulus, and rising vaccination rates, pullbacks should not last very long and any potential corrections are likely to be shallow, presenting an opportunity to add to equities.
The views expressed are provided for information only and are not to be used or considered as an offer or solicitation to buy or sell securities or investment products. To determine which investment(s) may be appropriate for you consult your financial advisor.
- The economic forecast set forth in this presentation may not develop as predicted, and there can be no guarantee that strategies promoted will be successful.
- Data provided by LPL Financial and FactSet.
- Indexes are unmanaged statistical composites and cannot be invested into directly. Index performance is not indicative of the performance of any investment and do not reflect fees, expenses, or sales charges. All performance referenced is historical and is no guarantee of future results.