July 20, 2021
Stocks don't need a reason to flop. Feel free to dismiss Monday's 2% decline in the S&P 500 as a statistical half-sneeze. Since 1950, the index has averaged two 5% drops a year, according to Lindsey Bell, chief investment strategist at Ally Invest.
But assigning blame is more satisfying, and two easy culprits stand out: a Covid-19 surge and peaking growth.
Cases of Covid-19, especially the fast-traveling Delta variant, are rising in many parts of the world. Will that lead to new, widespread lockdowns? J.P. Morgan says no, because mortality has fallen. But the effect on growth is unclear. I booked travel for a family vacation in late August, and now virus cases are surging at our destination. We haven't canceled, but we're not ruling it out. Assuming we're not the only wait-and-seers, Delta could yet trim demand, even without lockdowns.
With or without more Covid-19 cases, the peak year-over-year earnings growth rate is surely in. The second quarter of 2020 was the first full lockdown quarter, and a dreadful one for company results. Against that easy comparison, Wall Street predicts that companies in the weeks ahead will report 63% earnings growth for the second quarter of this year. But for the third quarter, the estimate is much lower, 23%, and more important than slowing growth might be that upward revisions in earnings estimates have been getting smaller.
"While we don't expect to see earnings declines anytime soon, we are certainly at an inflection point," wrote CIBC Capital Markets stock strategist Ian de Verteuil in a recent note to investors. "It would not surprise us if the scale of earnings surprises moderates."
One culprit to rule out is inflation. A sudden surge in consumer prices that began three months ago led some investors to wonder whether bond yields would push higher, luring stock investors, and denting stock valuations. But now, the 10-year Treasury yield has fallen to 1.2% from 1.6% over the past three months. The bond market seems supremely confident that faster inflation rates won't stick–so confident that it raises questions about the economic recovery.
As for what stock investors should do, Wall Street has advice to fit any taste. Get defensive, Morgan Stanley strategist Michael Wilson urged on Monday, upgrading the consumer staples sector to Overweight from Neutral. "Boring can be beautiful if the broad market begins to falter," wrote Wilson. He also named the healthcare, real estate investment trust, and telecom sectors as well-positioned now. He downgraded materials to Neutral.
But strategists at J.P. Morgan argue that investors have turned away too quickly from stocks that benefit from economic reopening. "We expect the reflation trade . . . to bounce imminently as Delta variant fears subside and inflation surprises persist," they wrote on Monday.
Here's some good news: CIBC's de Verteuil points out that the S&P 500 returned 10.4% a year over the 15 years ended 1988, when the inflation rate averaged 6.6%; then 13.6% over the next 15 years, with average inflation of 2.7%; and then 11% in the 15 years since, with inflation averaging 2%. His point is that stocks can hold up to varied economic backdrops.
Even after Monday's decline, the S&P 500 trades at 22.6 times this year's projected earnings, which is pricey compared with its history, so don't expect double-digit average returns in the years ahead. But, don't flee stocks. Bonds are handy in a pinch, like Monday's selloff, but the 10-year Treasury pays four percentage points less than the latest reading on inflation. Long-term, paying these prices for stocks is easily a better deal than that.
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