Stocks continued their ascent in the 1st quarter of 2021, fueled by the optimism of a reopening economy, the rollout of the COVID vaccine, and further stimulus from Washington. Financial market leadership this year has oscillated between domestic stocks and foreign, growth and value, and large company stocks versus small. As of the end of the 1st quarter, the S&P 500 was up 6.2%, the MSCI EAFE index of established foreign economy stocks was up 3.5%, and the MSCI Emerging Markets index was up 2.3%. Foreign market returns were weighed down by a bounce in the U.S. Dollar. A strengthening of the Dollar runs contrary to what one would expect in the face of trillions of dollars of stimulus, but the weakness we saw last year did seem due for a pause.
By the end of the 2nd quarter of this year, operating earnings for the S&P 500 are expected to have fully recovered to the same approximate level as they were at the end of 2019, prior to the COVID pandemic. However, as of April 16th, stock prices for this index are about 30% higher than they were at the end of 2019, making valuations very high and thus reducing the expected forward returns for this index. Other segments of the financial markets likely offer better prospects. Stocks do still remain attractive relative to bonds, even with the recent jump in the yield of the 10 year Treasury bond. Based on my calculations, the yield on the 10 year would need to rise to 2.47% for stocks and bonds to be fairly valued relative to each other. The 10 year yield as of April 16th was 1.57%.
I mentioned in my first quarter letter that I believe we are beginning to witness a rotation in leadership in the financial markets, with previously underperforming asset classes (foreign stocks, mid and small company stocks, and value stocks) regaining leadership for what could be a significant period of time. This theme gained traction during the 1st quarter, as small company stocks vaulted 18.2% as measured by the S&P SmallCap 600. Mid-cap stock returns were in the low teens, and value stocks of all sizes greatly outpaced their growth stock brethren.
Bonds were less fortunate, with the Bloomberg Barclay’s U.S. Aggregate index down 3.4% in the quarter. Long-term government bonds fared even worse, down in the neighborhood of 13%. With interest rates being near historic lows, long-term bonds are very risky due to the inverse relationship between bond yields and prices.
In my view, inflation continues to be the greatest risk to the financial markets. While inflation has historically been positive for stock market returns, a sharp rise could disrupt the financial markets. Inflation is expected to jump this year when compared to last year’s COVID-induced shutdown. The Federal Reserve is of the view that this jump will be mild and transitory. However, if the Fed underestimates the risk and falls behind the curve, sharp increases in the Federal Funds rate would likely derail stocks and bonds for a while.
The financial markets are said to be forward looking. At this point, one would think the economic recovery may already be factored into stock prices. How much longer stocks can continue their ascent is anybody’s guess. Some investors lose sleep over the prospect of volatility in the financial markets. Volatility is inevitable. The challenge with trying to avoid volatility is nobody knows when it is going to begin, how deep it will be, and how long it will last. A better strategy is to have an appropriate asset mix for your time horizon, liquidity needs, and risk tolerance, and plan to ride out the periods of volatility.
If you have concerns about volatility and would like to review our strategy for your portfolio, please reach out to us to schedule a meeting.
Sincerely,
Glenn S. Rank, CIMA®
Certified Investment Management Analyst®
President
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· The S&P 500 is an unmanaged index of 500 widely held stocks that’s generally considered representative of the U.S. stock market. The S&P SmallCap 600 seeks to measure the small-cap segment of the U.S. equity market. The MSCI EAFE index and the MSCI Emerging Markets index are unmanaged indexes compiled by Morgan Stanley Capital International that are generally considered representative of the developed international stock market and emerging international stock market, respectively. International securities involve additional risks including currency fluctuations, differing financial accounting standards, and possible political and economic volatility, and may not be suitable for all investors. Investing in emerging markets can be riskier than investing in well-established foreign markets. Investing in small cap stocks generally involves greater risks, and therefore, may not be appropriate for every investor. The Bloomberg Barclays U.S. Aggregate Bond Index is a broad base, market capitalization-weighted bond market index representing intermediate term investment grade bonds traded in the U.S.. Inclusion of these indexes is for illustrative purposes only. Keep in mind that individuals cannot invest directly in any index and index performance does not include transaction costs or other fees, which will affect actual investment performance. Individual investor’s results will vary.
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