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Stock Rally Expected to Normalize in Second Half of 2021

Though the market's ascent may moderate, historically strong earnings growth remains the most important influence for long-term equity levels.

To read the full article from Mike Gibbs and Joey Madere, CFA, Raymond James Equity Portfolio & Technical Strategy, see the Investment Strategy Quarterly publication linked below.

Key takeaways

  • The most important influence for equities over the long term is earnings, and this strong economic recovery is driving historically strong earnings growth.
  • While equity market performance has been historically strong over the past year, it is normal for year two of a bull market to experience a moderation in its rate of ascent.
  • We continue to recommend a pro-cyclical stance to portfolio positioning, as the areas with increased leverage to the economic recovery are likely to outperform.
  • We favor value over growth with new money and recommend building exposure as relative momentum builds over time.

Rapid vaccinations (more than two-thirds of US adults have received at least one dose) have spurred a sharp reduction in daily new COVID cases and hospitalizations since the start of the year. This has resulted in a swift economic reopening which, boosted by enormous amounts of stimulus, is likely to push 2021 economic growth to its fastest pace in almost 40 years.

This economic momentum remains, with manufacturing and services surveys continuing to advance at very strong levels. In fact, the sharp rate of recovery is creating inflation concerns for investors as supply has been unable to meet this heightened demand. This dramatic demand versus supply imbalance could last for months, but it should abate over time as stimulus ebbs and supply chains untangle. Productivity growth (due to economic digitization) should also help offset inflationary pressures, and S&P 500 corporate margin estimates continue to climb higher. Importantly, the Fed is expected to remain accommodative as the labor market recovery still has a way to go, and rate hikes will come because the economy is strong. The risk of over-tightening remains minimal.

Earnings

The most important influence for equities over the long term is earnings, and this strong economic recovery is driving historically strong earnings growth. First quarter earnings season posted one of the strongest upside surprises in history with S&P 500 earnings growth finishing up 49% year-over-year (more than double the 21.6% consensus expectation). This is leading to markedly higher earnings revisions for 2021 and 2022, with upside to estimates remaining in our view. In fact, we believe S&P 500 earnings will hit $200 in 2021 (45% growth year-over-year and ahead of the current $190 consensus estimate).

Chart showing that over the last 20 years, S&P 500 earnings growth has been closely tied to the index's price level.

As earnings continue to recover, elevated valuation multiples should normalize in the back half of the year. The S&P 500 currently trades at a 25x price-to-earnings (P/E) multiple (down from a 28x peak) which we believe will move directionally toward pre-pandemic levels (~22x) by year end. The upshot is that we do not believe this normalization in valuation will outweigh robust earnings growth, providing further upside to equities – this $200 earnings estimate and 22x P/E assumption results in a base case S&P 500 target of 4,400 by year end.

Market moving events

While equity market performance has been historically strong over the past year and we remain positive, it is normal for year two of a bull market to experience a moderation in its rate of ascent. Inflation, Fed communication, and the debate over stimulus/taxes are likely to gain significance in the back half of this year. These items – among many others – can lead to short-term volatility, something that has generally eluded equities in a broad sense following positive vaccine news in early November.

The largest drawdown for the S&P 500 since then has been ~5%, while it is very normal and healthy historically to have 7-12% pullbacks throughout a year. We view the fundamental and technical backdrops as supportive over the intermediate term, and continue to see the positives outweighing the potential negatives; thus, we recommend using potential weakness as a buying opportunity. As has been the case for months now, volatility is likely to be seen more significantly beneath the surface as sector rotation continues to play out – leaving plenty of opportunity for active investors.

Investment Strategy Quarterly

Read the full
Investment Strategy Quarterly


Investment Strategy Quarterly is intended to communicate current economic and capital market information along with the informed perspectives of our investment professionals. You may contact your financial advisor to discuss the content of this publication in the context of your own unique circumstances. Published 7/1/2021.