U.S. equities, as measured by the S&P 500 Index, returned more than 8% (including dividends) in the second quarter, bringing year-to-date performance solidly into double-digit territory. Non-U.S. stocks, as measured by MSCI’s All Country Worldwide Ex-U.S. benchmark, returned more than 5% in the second quarter including dividends, and is up more than 9% year-to-date.
While numerous factors drove market action in the quarter, a key driver of U.S. equity performance was exceptional first quarter earnings results (reported throughout the second quarter). In aggregate, first quarter earnings for the S&P 500 Index grew nearly 50% on remarkably strong sales growth of 12%.
Solid product margins, tight operating expense controls, and measured capital spending enabled many companies to deliver the strongest incremental margins (measured as the additional profit generated by each additional dollar of sales) and free cash flow production since 2009, when the U.S. economy was emerging from the great financial crisis.
As earnings exceed expectations and the economic outlook brightens, investors’ outlook for future profits continues to rise. At the beginning of 2021, the consensus estimate for S&P 500 Index earnings per share was $165, representing a strong 20% recovery versus 2020 and roughly even with 2019, an impressive improvement in earnings given the chaos of 2020.
Today, however, investors now expect 2021 earnings per share of $193, which is 17% higher than they expected a mere six months ago, now representing 40% growth over 2020. This rising optimism extends into 2022 and beyond. All else being equal, rising earnings estimates bode well for stocks, as prices tend to reflect expectations of future profits.
From a valuation perspective, price to earnings multiples remain high relative to history, but they have fallen over the last six months. It is important to note that nearly all investors and market observers have been expecting strong earnings results for 2021 in light of easy year-over-year comparisons from 2020. We entered the year with valuations looking particularly stretched relative to history – partially due to high expectations and partially due to other factors such as low interest rates. The S&P 500 was trading at a lofty 22.6x expected 2021 earnings, which compares to a 20-year average of 15.7x. The market multiple has fallen two points over the last six months to 21.5x, yet stock prices have appreciated because earnings have been so much stronger than expected (see chart below).
Howland Capital’s Investment Committee enters the second half of 2021 with a guarded, yet optimistic outlook for global stock markets. We still view equities as the most attractive asset class, especially as prospects for further upside to earnings remain strong. Equities may turn out to be a good source of inflation protection given earnings and dividend growth. Only time will tell if accelerating inflation (and the problems it
can cause) is here to stay… and whether the Fed’s prolonged dovishness will ultimately come back to bite.
However, we are mindful of the potential for accelerating inflation and rising interest rates, both of which have the potential to derail the equity markets.
Internationally (as well as in the U.S.), we are hopeful for continued progress in the battle against COVID-19. Vaccination rates are improving, albeit slowly in some countries, which bodes well for accelerating economic activity. At an average 15.7x, non-U.S. stock market valuations remain more favorable compared to their U.S. counterparts. The same is true for dividend yields. We remain encouraged by the trends we are seeing, and our positive, long-term outlook for international equities remains intact.
In the U.S., strong sales momentum and profit margin trends suggest there could be more upside to 2021 and 2022 earnings estimates. Valuations, while still elevated, are less demanding than they were earlier this year. This implies forward earnings growth is not fully reflected in current multiples, which should insulate the market, to some extent, against meaningful valuation erosion. We see the potential for further valuation normalization in addition to stock price appreciation moving forward. These are but a few reasons for optimism, but the U.S. stock market narrative is shifting from one focused on earnings recovering from the war against COVID-19, to one focused on inflation, interest rates and the timeline surrounding anticipated changes to monetary policy.
With regard to the Fed and interest rates, concern about rising rates is particularly impactful on the outlook for stock prices right now. Over the last few years, the bond market (and falling interest rates) significantly influenced valuations of the highest growth stocks. With rates low, overall economic activity muted, and earnings growth more scarce across the economy, investors have been paying higher and higher valuation premiums to own growth stocks.
Today, the stocks most highly correlated to the bond market (i.e. stocks that fall if rates rise) make up a disproportionate amount of total stock market capitalization, and their
valuations remain elevated compared to history. On the flipside, the stocks most negatively correlated with the bond market – in other words, stocks that benefit when interest rates rise – represent a disproportionately small part of market capitalization, and their valuations are trading at a discount. With the prospect of rising interest rates – something the Fed has “started to talk about starting to talk about” – one can see the key risk that rising interest rates could pose to aggregate stock market performance moving forward.
What are we doing to position client portfolios amidst the market crosscurrents? First and foremost, we reiterate the importance of owning the securities of companies capable of meeting or beating earnings expectations. At the same time, we are mindful of expectations and valuations.
Further, we rely on more than five decades of experience serving our clients when it comes to portfolio diversification, ensuring broad sector and value exposure in the event that interest rates rise and inflation climbs faster and for longer than expected. In any market environment, particularly in today’s, we are focused on owning companies with strong pricing power and durable growth opportunities that are more immune to changes in the macro environment.
It is anyone’s guess as to what the near term holds for stocks, but using history as a guide, we are taking a long-term approach with eyes wide open to the key risks of today’s world, because that is what we believe will best serve our clients and their investments.