What Did We See?
- U.S. Large Cap stocks, or the S&P 500 index, were up less than 1% in May.
- The developed market of Japan was down about 1%.
- Europe and the U.K. were up about 3% and 1% respectively.
- Emerging Markets were up more than 2% and Asia (Ex-Japan) were up more than 1%
- Global fixed income returns were all positive led by Global Inflation-Linked bonds.
Where Do We Stand?
- The market rally stalled a bit after a very strong start to the year.
- Valuations remain stretched however the probability of a recession remains low.
- The time horizon for a pullback or correction is nearer than markets are anticipating.
- I remain in a position to take advantage of opportunities as we anticipate further economic growth due to pent up demand.
- I continue to rebalance your accounts accordingly.
Although “sell in May” did not bring the oft-cited negative returns this year, equities did experience a bit of a stall last month. While the economic data was as strong or stronger than expected, markets showed some constraint in the face of higher inflation. Whether or not this inflation is “transitory” (as the Fed has claimed) is yet to be seen. Immense global fiscal support continues to buoy asset prices and is helping to whither the fears of another wave of the Coronavirus disrupting the recovery. The data on vaccines continues to impress with many developed economies citing 50% or more of adults fully vaccinated. The recovery is on track and looks to continue to drive economies around the globe for at least the remainder of the year.
Inflation Watch
In the US we saw the Purchasing Manager’s Indexes for both manufacturing and services rise to a record. This is a blessing and a curse. It shows that demand from consumers remains robust while at the same time corporations face rising input costs. The engine of our economy cannot be turned on like a light switch. As one would expect, it will take some time to bring supply fully back on line. The result has been inflation rising well above average. This is OK as long as it doesn’t rise to the point where the Fed will have to act. Right now the fears of an unexpected rate increase remain contained. However, should the Fed have to act before the economy is fully back to work, problems could arise. To wit, if the Fed raised rates before we are back at full employment I would expect the market to not take that well. We’ll just have to wait and see.
Rolling Corrections
In the meantime, US corporations are healthy. Earnings for the first quarter of 2021 were much stronger than expected. While the market had expected about 20% growth (year over year), we got 47%. This is fantastic but did not come with some hidden messages. The S&P 500 rose less than one percent in May. At the same time Consumer Discretionary stocks and Technology stocks saw a meaningful pullback. The Technology sector was down almost 1% while the Consumer Discretionary sector was down more than 3%. Looking deeper there were many stocks that saw pullbacks of 10% or greater. From a headline perspective, I would call this a mini-correction. That is something we have been looking for. Unfortunately, it was not enough to the market having fully corrected, something we have been calling for in recent posts. There is now the possibility that we see a “rolling correction”. That is different sectors of the market correct (go down more than 10%) at different times as we move through 2021. This is not a bad thing, it just doesn’t give us a clean slate to move forward on.
Global Support
Around the world we see a lot of the same. Europe has picked up their vaccination rates and the prospect for growth to return there has risen. The services sector there is seeing a rebound as restrictions ease. The UK is experiencing extremely strong demand for goods. In fact, clothing sales grew 70% month over month in the kingdom! However the supply bottlenecks have meant that demand is not being met while supply prices continue to increase. The knots need to be worked out. The Emerging Markets continued to provide strong returns while Chinese stocks looked to begin a recovery after having corrected by almost 20% in March. Valuations there now look reasonable, something the US is missing.
Warning Signs
Technically speaking there are some budding warning signs that a correction (5% – 10% move lower) is in the offing over the next few months. The first sign is complacency leading to excessive risk taking. We have seen evidence of this in meme stocks (GME, AMC, etc…), cryptocurrency and SPAC’s. A measure of complacency, the VIX index, recently stood at about 17. When the VIX gets below 15 or so it tends to foretell a correction. The second sign is timing. The length of time between corrections is typically about 18 – 22 months. We now stand at 14 months since the last pullback of 10% or more. It’s not “long in the tooth” yet but it’s closer to a potential correction than we’d like it to be. Other indicators are high levels of margin debt, high levels of equity offerings, high market value to GDP and extremely low earnings yields. All put together and we see a market we’d call “frothy”.
Conclusions
Until such time as the market fully corrects, we are in a bit of a pickle. Fundamentally, the economy is strong and getting stronger, the market is resilient and continuing to be so and the Fed is quiet. These are all positive results and should keep the markets as buoyant as they have been. Yet, we continue to struggle with too-high valuations here in the US. With a forward P/E ratio on the S&P 500 of over 21, we are still well above the historical norm for this valuation metric. I would be more comfortable if we were in the 18 or 19 range. That is still high by historical measures, but more reasonable assuming we continue to grow out of the pandemic induced stall. Thus, one of two things (or both!) has to happen. Earnings have to grow astronomically or prices need to retreat or stall for a time. Either way, your asset allocation has you prepared while we wait for a day of fully open economies around the globe.
If you have any questions or have experienced any changes in your financial situation please do not hesitate to Contact Me.
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