Fed Policy Drives Market
The election resulted in a split government, commonly referred to as gridlock. Of course, the twin Georgia senate races could impact this conclusion come January 5th. From the FDR administrations onward, gridlock posted the best stock market returns vis-a-vis one party controlling both the White House and the legislatures. While the election was important, the leadership of Federal Reserve and the resulting monetary policy matters most. Recent examples include the unprecedented policy response witnessed in March 2020 given the virus and lockdown. Another example is Chairman Powell’s policy about-face in December 2018, after systematically tightening to the point where the economy was grinding to an eventual halt.
Profit Cycle Ahead
Since late summer, we described the various underpinnings supporting a strong upcoming profit cycle which will benefit more economically sensitive segments of the stock market. Initially, the unprecedented response by key Central Banks rested liquidity concerns, providing bedrock for a recovery. Multiple fiscal policy actions ensued across the globe. Other drivers here in the US include a powerful housing cycle underway and lower gasoline pump prices. Rebounding manufacturing data accompanied by a reversal to historically high savings rates provide further economic momentum.
Broader Market Recovery
Again, a broad economic rebound benefits companies more sensitive to the economy. From current depressed levels, their earnings growth can revert much higher as the profits cycle materializes. This is important for stocks as changes in profits drives changes in markets and stocks.
Through the third quarter of 2020, six stocks were responsible for ~95% of S&P 500 performance. These “industry disruptive” companies have grown revenues and profits at enviable rates and, importantly, regardless of economic conditions. Of course, these familiar companies are “FAANGM”, i.e., Facebook, Amazon, Apple, Netflix, Google, and Microsoft. Their growing dominance attracted a lot of investor capital resulting in rich valuations. If the strong profits cycle materializes, investors will rotate funds from these aforementioned giants and into the more cyclical companies. Why? Cyclicals year-over-year earnings growth prospects will be stronger (figure 2). Moreover, in the early stages most profits recovery cycles, small and mid-cap stocks outperform due to their economic sensitivity.
Specifically, three of the more sensitive segments of our economy – industrials, materials, and consumer discretionary, are expected to grow earnings by about 49% over the next 12 months. In contrast, the S&P 500 earnings is forecasted to grow by 19%. Technology & Communication Services companies are estimated to grow 14%. As a result, a rotation from Information Technology and Communication Services stocks into the more cyclical stocks is possible.
And, indeed, a look at returns in this fourth quarter of 2020 suggests this market rotation is underway.
Steepening Yield Curve
The yield curve is steepening (figure 3), which typically indicates a rebound to mild inflation levels (from depressed levels) and stronger economic growth. So, the bond market trend corroborates our profits cycle view.
Risks to Economic Recovery
There are always risks to any outlook offered. Key risks include:
- Increasing infection rates resulting in aggressive policymaker reaction
- A setback in the vaccine rollout
- Waning consumer confidence (deters draining the elevated savings rates which we view as pent-up consumer demand)
- Stimulus held captive by political jockeying
- Permanent job loss. Equally, every economic cycle climb-out features permanent job losses
OPINIONS EXPRESSED IN THIS REPORT ARE INTENDED SOLELY AS GENERAL MARKET COMMENTARY AND DO NOT CONSTITUTE INVESTMENT ADVICE OR A GUARANTEE OF RETURNS. The third- party information used in this document has been obtained from various published and unpublished sources considered to be reliable. However, Venturi cannon guarantee its accuracy or completeness and thus do not accept liability for any direct or consequential losses arising from its use.