Rida MorwaMarket Outlook: The Markets Beyond 202130 May 2021 1:27 PM ET
Summary + The equity markets continue to show resiliency in the face of any negative news.
+ The outlook beyond the year 2021.
+ Comparing the Bull Market of the Year 2000 with Today's Bull Market.
+ Are equities overvalued today? Will interest rate hikes by the Fed derail the bull market?
+ Current Outlook: Where do the Markets go from here?
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Market Outlook, 30 May 2021
The stock markets remain very resilient despite all the negative news that is spreading fears among some investors, including inflation fears, and the impact of higher capital gains taxes and corporate taxes. The S&P 500 index has broken above the 4200 level again to show signs of continuation, and at this point, it looks that this market is ready to make a fresh, new high. This would be an all-time high, which of course would be very bullish.
The leaders again in this rally are "value stocks" as growth, technology, and momentum stocks continue to suffer as a result of higher inflation and the impact of higher taxes. The HDO portfolio had another great week.
As noted in previous market updates:
Technology, big growth, and momentum stocks are suffering a double hit on the taxation front. The first hit is corporate taxes: The latest research shows that large-cap stocks' earnings will fall as much as 9% in 2022 based on the current tax plans. The second hit is on the capital gains taxes: Many high net worth individuals are selling (or will sell if they are still able to) their growth stocks this year to lock in lower taxes, and buy them back next year. They might also instead buy "dividend stocks" which are taxed at lower rates because most of the returns come in the form of dividends and not capital gains.
Low interest rates are great for all equities in general, but particularly for "growth stocks". The valuation of any stock is calculated based on "the present value of its future cash flows". This formula takes into account "interest rates" and "earnings growth". A company with rapid growth will see its valuations substantially decline when a slight increase in interest rate is seen. This is the case for growth stocks that are already trading at lofty valuations. Once interest rates start to rise, all of a sudden, these lofty valuations will look even loftier. The prices will have to come down in order to reflect the new realities. In contrast, value stocks do not have much growth built-in. These tend to be established businesses with high recurrent cash flows. So their valuations are not as sensitive to interest rate hikes.
Growth stocks are unlikely to come back in favor this year. I expect "value stocks" and "value dividend stocks" to continue to lead this rally throughout 2021.
The Drivers Of the Current Bull MarketThe economic and earnings fundamentals are strong. Economic data continues to show strength – U.S. Real GDP growth is expected to rise to 8.6% (annualized rate) in Q2, and 6.4% (year-over-year) in 2021. The economy now is running at maximum acceleration. On the earnings front, first-quarter results were sensational, with over 85% of companies beating estimates and increasing their forecasts for 2021. We have also many companies increasing dividends, and initiating stock buybacks. HDO's stocks got a big share of those dividend increases, and some were on the order of 40-50% over the last dividend, such as from NEWT (NEWT), ATAX (ATAX), and CLNC (CLNC).
The technical picture is perfect and indicates a continuation of a secular bull market.I keep highlighting every week that
the biggest driver in any bull market is liquidity and excess money held by investors. The system is swimming in trillions of excess liquidity from the stimulus plans and savings accumulated by consumers during the pandemic. Furthermore, there is a "bubble of cash" held by investors that is still sitting on the sidelines, held in savings accounts, money markets, and CDs, earning next to nothing. There is evidence that some of these funds are slowly flowing into the equity markets, and supporting higher prices. Additional liquidity is being injected into the system (whether it is needed or not). The current administration is on a spending spree. A negotiated "infrastructure plan" likely to be around $1.4 trillion in additional liquidity will hit the economy soon.
A Fading Dollar adds "More Liquidity" for U.S. StocksA weakening dollar is adding further support to U.S. stocks and attracting foreign investors as the market soars to record levels. The U.S. dollar has been falling against other international currencies mainly due to ambitious spending plans in addition to the large stimulus plans, borrowing, and dollar over-printing during the pandemic and following it. Below is the chart of the U.S. dollar index during the past 12 months.
Source: tradingview.com
The falling dollar is set to attract foreign investors, who spend on average an estimated $300 billion on U.S. stocks each year. They were the largest buyers of U.S. equities during the Covid crash of 2020.
A weakening dollar has historically been a big catalyst for foreign investor demand for U.S. stocks. This adds even more liquidity for U.S. stocks and helps drive equity prices higher.
Outlook Beyond the Year 2021While the bull market of the year 2021 is being supported by strong economic growth, this will not be the case in the year 2022. The impact of the stimulus plans and the pent-up demand will wear off by next year, so economic growth should significantly slow down. This means that the current valuations of the S&P 500 index may not be supported by the earnings growth next year. This is also another blow for growth stocks.
However, this bull market will not be over next year and will continue most likely until the year 2023.
+ Are the markets currently overvalued?
+ What will be the driving force for the bull market next year?
+ Which risks do we have to keep watching for?
+ What will end this secular bull market?
+ What are the signs that I will be looking for to guide our members to move our portfolio into a more "defensive position?"
In order to address these questions, let's start by comparing the current bull market with the bull market that started in the early 2000s and which led to the "great financial crisis" of 2007-2008.
Comparing the Bull Market of the Year 2000 with Today's Bull MarketLet us first have a look at the S&P 500 chart from the year 2002 where the last phase of the bull market began (prior to the current one which started in 2010) through the year 2007-2008, which we call the Great Financial Crisis.
The current bull market today is mostly a "liquidity-driven" one and is very similar to the bull market that we saw back in the early 2000s. Both have little do to with economic growth and this is why a slowing economic growth will not derail today's bull market.
While currently the liquidity is being pumped by the Federal Reserve and the Government, back in the years 2000, it was done by the banking system through irresponsible banking practices. The end impact? Wealth brings more wealth. More wealth brings more speculation. More speculation leads to higher asset prices. And eventually, an "asset bubble". And finally.... a bubble burst.
Frankly, this is where I think we will eventually be heading. It is not a matter of if, but a matter of when. In the meantime, there is a huge amount of money to be made, both in terms of dividends and capital gains. Also if we time it correctly, and this is our aim, we will take a defensive position in time, so that we can absorb any shock and still have a good defensive income-paying portfolio. The good news is that we still have years to enjoy this bull market. I will go step by step to explain the situation today and compare it to the years that led to the "asset bubble burst" in the year 2008.
Are Equities Overvalued Today?First, let us assess if the markets are overvalued today. For those skeptics who still insist on using the Price/Earning ratio valuations, I will do so and compare today's valuations with those of the years prior to 2008. Note that the P/E ratios are the worst valuations to use because they do not factor in current yields (Treasury yields or Federal Fund Rate yields) which are key and should be used to get any accurate results.
Source: MacroTrends
As we can see above, the railing P/E ratios today are at around 40x versus 120x prior to the bubble burst. Note that the forward P/E ratios for the year 2021 are set to be much lower than 40 times due to acceleration in earnings. According to the WSJ, the forward P/E ratio of the S&P 500 index is at 22.5 times. Therefore today's stock valuations are clearly inexpensive using this method.
Valuations Based on 'Earnings Yields'Perhaps, one of the best valuations around is the one based on comparing the "Earnings Yield" (or earning generation) of the S&P 500 companies versus the "10-Year Treasury Yield.
Note that at the time of the year 2000 bull market, the 10-year treasury yields were running between 4% to 5%. Today they are below 2%.
Source: MacroTrends
So let us look at the valuations based on the "earnings yield".
The S&P 500 index estimated "earnings yield" for the year 2021 is at 4.3% while the 10-year Treasury is only earning you 1.64%. Clearly, there is little advantage in holding the 10-year treasury. Your earnings spread (or gain) by investing in equities is at 2.66%.
Source: Yardeni.com
Back in the year 2006, one year before the "great financial crisis", the "earnings yield" of the S&P 500 index was at 5.76% with the 10-year rate yielding 5.0%. So your earnings spread was about 0.76%, much less than the 2.66% that you are earning today by investing in equities.
So clearly, we made the case that equities today are not overvalued based on both methods used above, but rather reasonable and possibly undervalued.
Market Risk: Will Interest Rates Hikes By The Fed Derail the Bull Market?The main risk being discussed by many analysts today: Would a Federal Reserve policy mistake or "misstep" by hiking interest rates too early or too late derail this bull market?
The way things are looking today, there is going to be a rate hike next year, probably by 0.25% or possibly by 0.5%. This will probably happen mid or end of 2022. How will this bode with the current bull market? It will for sure have a knee-jerk impact at the beginning but will be short-lived and not derail a bull market. Remember, this is a bull market that is flush with liquidity. Again, let us look back at the bull market of the year 2000.
Source: St. Louis FED
From the year 2004 till the year 2007 the Fed Fund Rates were hiked from 1% to 5.2% (or +by 4%) in 3 years and the bull market did not budge!
So a 0.5% hike, or 1%, or even a 1.5% hike is not going to derail this bull market.
Here we need to note two items that are very important and that got the Fed's hands tied as such they may be unable or unwilling to hike rates by too much:
The Fed is not willing to risk derailing the economy and risk having another recession which will be extremely costly to "resolve", and probably more costly than the COVID crisis. I think this is out of the question for the Fed right now. This will tie the Fed's hands about how much they will be willing to increase the Fed Funds rate.
More important: Even if the Fed becomes very hawkish and willing to hike rates, it is going to face very tough opposition from politicians from both parties. Remember that the fiscal deficit has ballooned since COVID, and any small increase in Fed rates is going to cost the government a fortune in interest payments to repay. The government may settle for more inflation and less "Federal Deficit" in case they are faced with having to raise rates aggressively.
Because of both reasons above, I believe that the Fed has few tools to fight inflation or "runaway inflation". This is another reason yet that we at HDO have been preparing our portfolio for higher inflation since the beginning of 2021. We are fully ready and prepared if inflation accelerates.
Going back to valuations: A hike of 1.0% by the Fed will not result in stocks being overvalued compared to the year 2006 because you would still be earning today a higher spread of over the 10-year Treasuries.
Current Outlook: Where do The Markets Go From Here?This bull market has at least two more years to run. The last phase of the bull market, as I will explain in my next market outlook, is when stocks see their biggest and fastest gains in the shortest period of time. This will be one of the most interesting and fascinating times to be invested in and experience the markets. But we are not in this last stage yet. We are on the one prior where we can seek undervalued opportunities because the markets are not overvalued and overstretched.
We have been seeing some volatility lately, and it is likely to continue through the summer. But as with any bull market, large unexpected market gains can surprise you more than the "unconventional" pullback.
The next target for the S&P 500 index is at the 4400 level, with massive support at the 4000 level to the downside. I believe that there is a good chance that the S&P 500 index will close the year at or above the 4600 level, or roughly 9.5% higher from here. The year 2021 is set to be a fantastic one for stocks in general, and especially for our "model portfolio'. Again, we are set to beat the S&P 500 index, and all major indexes and deliver stellar results to our members while collecting our recurrent income.
My Next Market UpdateIn today's outlook I have explained:
+ That this bull market is liquidity-driven and not only based on economic fundamentals. Even if economic growth slows down, it would not impact this secular bull market.
+ Equities are not expensive, using two valuation metrics (P/E ratios and Earnings yields). We can even argue that they are cheap.
+ I tackled one of the major risks that is worrying investors today, which is future rate hikes by the Fed. I explained that the next rate hike is likely to be next year, and it will only result in a knee-jerk reaction. It should not impact the bull market.
+ I also explained that the Fed's hands are tied and that the possibility of aggressive future rate hikes is unlikely. This is good news for equities.
In my next market update, I will expand further and explain:
+ The four phases of the Bull Market
+ Which phase of the Bull Market are we in today.
+ The last phase of the bull market is the one where we see the biggest and fastest gains in the shortest period of time. It is also the most fascinating one but can be dangerous if not watched carefully because this is where it all ends.
+ What are the signs that I will be looking for that would indicate that the bull market is over?
+ When will be the time to move into a more "defensive" dividend portfolio.
Have a great Sunday!
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