US Market Viewpoints Q1 2021

The "Everything Rally" continued into 2021 with most asset classes moving higher. Broader stock market indexes like the S&P 500 and Dow Jones Industrial Average closed the quarter at or very near all time highs. Other assets like Meme stocks, homes, cryptocurrencies and commodities surged in the quarter. Asset prices were pushed higher on the back of a new stimulus bill and encouraging trends in vaccination rates in the US. One investment category that dropped off the "Everything Rally" train were bonds. Bonds pulled back about 3% this quarter. The 10-year treasury bond saw its rate move from 0.93% at the start of the year to close the quarter at 1.73%. As a reminder, when rates move higher, bond prices decline. This was the most challenging quarter for bonds since 1980 (Yes, 40 years!)

This quarter saw a leadership change among market strategies. Since 2015, growth stocks have outperformed all other strategies by a wide margin. Growth stocks passed the market leadership baton to value stocks this quarter. Large cap value stocks rallied 11.1% and small cap value surged 20.9% over the last three months. Growth stocks managed a positive return but lagged. The shift from growth to value can be attributed to the change in interest rates and investors rotating out of stocks trading at rich valuations. In rising interest rate environments, value stocks usually outperform. Industrial and financial companies are the top sector weights in the value index and they perform well during periods of rising rates. The highest valuation stocks saw a pullback because as rates move higher, it can cause market valuations to slim down, which hurts the stock market's highest valuation and speculative companies. Small cap stocks saw the best performance across the board. When economic growth is expected to be robust, small cap stocks outperform their peers.

Investment Strategy

Our investment strategy remains unchanged from where we ended 2020. We are overweight stocks and underweight bonds and cash. This tactical strategy has worked out well, as bonds have underperformed stocks so far this year. We plan to maintain this stance for the time being. Our stock holdings continue to be broadly diversified across geographies, strategies (value and growth), as well as market caps. Your portfolio has a tilt towards smaller companies and international as we see better expected returns for those areas of the market as we expect economic growth to be strong this year.

Outlook

Our outlook for the economy and stocks will diverge somewhat, but we are positive on both. We expect the US economy to set records for economic growth this year. While we are positive on stocks, we don't expect stocks to match the overall economy's strength. The reason is something we have discussed in our previous Viewpoints. Stocks are forward-looking, and much of the record moves from 2020 were in anticipation of 2021 being a terrific year for the economy. We think the US economy is primed to show the most substantial growth in decades this year. Goldman Sachs has forecasted they expect the US economy to grow at 8% this year. This would be the best growth rate since 1951. The $1.9 trillion stimulus bill and the vaccine rollout exceeding projected levels are providing a boost to the economic recovery. Consumers are in terrific shape. They have bank accounts flush with savings, new stimulus checks, and a strong desire to eat out, travel, and spend. We expect growth to moderate some in 2022 as the sugar high from stimulus wears off.

The Federal Reserve (Fed) reiterated that they have no intention to increase interest rates anytime soon. They are willing to allow the economy and inflation to run "hot" for a little while to return the economy to full employment. The Fed is able to control short-term interest rates, which is what we get paid in our savings accounts. The bond market investors dictate what interest rates look like if you want to borrow money for 5, 10, or 30 years. A good proxy to that is your mortgage rate. Interest rates in these markets have moved higher as investors want to be compensated for the added risk of inflation as well as because economic growth is improving. The struggle between the Fed trying to keep rates low while the bond market is pulling rates higher is something we will continue to watch. We expect intermediate and long-term interest rates to continue to move higher as the economy recovers. The Fed may be forced to lift short-term rates sooner than they hope. If the Fed does act in 2021 or 2022, this could create volatility in the stock market because it would be unexpected.

We are optimistic that stocks will continue to offer positive returns. Economic growth, strong stock buybacks, and improved earnings all lead us to be optimistic about stocks. While we are positive, we are not euphoric. The S&P 500 is still trading above its historical average, selling for 22.9x 2021 expected earnings. Further appreciation without earnings growth or companies beating earnings could be challenging. Retail investors (Robinhood Traders) have picked up the habit of trading stocks as a hobby during the COVID lockdown. As life returns to normal, many of these new Robinhood Traders may stop trading and revert to pre-pandemic activities. If this happens, you could see markets experience a slight pullback without fresh buyers entering the market. We are not projecting a significant sell off but think this might have a temporary impact on the markets.

The Biden Administration announced a multi-trillion infrastructure package. Roads, bridges, and communication infrastructure need an upgrade in the US. If this progresses, it will provide additional fiscal stimulus to an economy that is already well lubricated after the early stimulus package and pent-up consumer spending. This infrastructure spending is projected to be spread out over the next decade. To pay for the new infrastructure bill, taxes will likely need to go up. No one ever wants to see their taxes increased, neither do we. The market is beginning to price in that corporate taxes will increase slightly from 21% to 25%. The initial proposal from the Biden Administration is for corporate taxes to increase to 28%. Personal tax rates could also go up for the highest income earners. This is all preliminary discussions and is something that we'll monitor as it will have a considerable impact on the markets and investor sentiment this year.

Wrapping up, we are optimistic about stocks but have realistic return expectations. To see stocks have their 3rd double digit return year in a row, corporate earnings will need to outperform expectations.

Andrew Comstock, CFA

Principal - Wealth Advisor