We’ll address a single question in today’s Data section: “Was July 7th the top for the S&P 500 in 2021?” We’re not prone to alarmism, but this strikes us as an entirely reasonable question. The pandemic news flow is worrisome. 10-year Treasuries are clearly concerned about US/global growth. The S&P is expensive by any historical measure even if it does house some of the most profitable businesses ever created.
To give both sides of the argument a fair shake, we’ll list 3 reasons why the answer is either “Absolutely …. the market is done here” or “Nope – 2H 2021 should see new highs”.
Bearish case first:
#1: US stock prices rarely misjudge corporate earnings power in a significant way 3 years in a row. This is why seeing 3 straight years of +10 percent S&P returns is relatively unusual. It has only happened once since 2000 (2012: +16 pct, 2013: +32 pct, 2014: +14 pct), for example. Markets are reasonably efficient, so this is what you’d expect to see.
The problem is that, even after today’s decline, the S&P is still up +15.0 pct YTD after seeing a 31.2 pct advance in 2019 and an 18.0 pct gain in 2020.
Conclusion: the S&P may well have run ahead of itself in 1H 2021 and will pull back in the second half because corporate earnings can’t be as surprisingly good as the current anomalously strong bullish market requires.
#2: The 10-year Treasury yield is one half of the NY Federal Reserve recession model (3-month bills are the other), and the recent move lower for long rates puts us closer to the warning track than we should be at this point in the cycle.
At present, the 3M – 10Y spread is 1.24 points which, while still positive, is nowhere near a typical recovery (chart here back to 1982):
Conclusion: seeing Treasury yields decline so quickly is not in itself a bad sign but seeing them approach a 1.0 point spread over short term yields so early in a recovery is deeply troubling. No other recovery since the 1980s has had such a flat yield curve. None.
#3: Stocks discount 6 months out; how much certainty can we really have about the Q1 2022 US/global economy? We’re not talking about the numerous pandemic variants around the world per se, but how governments in the northern hemisphere will respond to the health challenges next winter.
Conclusion: combine this point with #1 (the S&P’s 1H 2021 strong return) and you can tell a reasonable story about how current stock prices do not fully reflect the risks of relatively new information about the spread of variant pandemic strains.
And now, the bullish case:
#1: There are enough signs out there that corporate earnings power is substantially better than expectations to believe the S&P can continue to rally. As we often mention in our Sunday evening reports, it’s pretty rare to see earnings estimates rise during a year. Usually, analysts start high and cut as the year progresses. That’s not the case this year, as this FactSet chart shows:
Conclusion: American companies are very good at generating profits, even in difficult or uncertain operating environments. And they’ve been guiding up on Q2 in recent weeks, so the above chart should continue to show steady improvement over the balance of 2021.
#2: If everything is so scary, why is the VIX only 19.0? This is the long run average for the CBOE VIX Index. If options traders – typically a pretty savvy lot – are not pricing in above-average 30-day volatility, then perhaps there’s less to worry about than the recent move on the 10-year Treasury would indicate.
Conclusion: We only get a truly “unusual” VIX when it hits 28, which is 1 standard deviation from the long-run mean, and we’re nowhere near that yet. This doesn’t guaranty a good 2H, but it does say we can remain long a little while longer to see how July’s Q2 earnings season plays out.
#3: The S&P yields the same as the 10-year Treasury (1.3 pct), and dividends should continue to increase in 2022 and beyond. Admittedly, this is not so much a bullish case as a rhetorical question. Why swap into the 10-year here when you get at least the same coupon owning the S&P 500 with the very real possibility of capital appreciation rather than just receiving par a decade from now? Yes, there have been times in the last 10 years when Treasuries yielded more than the S&P 500, but stocks ended up doing much better in the periods afterward.
Conclusion: once markets realize earnings will be fine (bull case point #1), lower yields should act as a valuation positive since lower discount rates create higher net present values.
Summing up: we read this list as pretty balanced, so our conclusion is that we’re in for some further volatility in July and August. Our recent vol seasonality analysis also points to that conclusion. We’ve been recommending lightening up for several weeks now, and for a while that looked like bad advice. While we do think the S&P can end the year higher, we still think caution is the better part of valor at current prices. There’s still a long way to go in 2021, and reloading on a correction will give better whole-year performance than simply riding out any storm that may arise.