Commentary | 2Q 2021
2021 Q2 Market Recap
In the second quarter of 2021, the stock market, as represented by the S&P 500 Index, produced a return of 8.6%. The market has generated a return of 15.3% for the first two quarters of 2021, and a return of 40.8% over the last four quarters. While these returns were favorable, subsets of the market produced higher returns for the year-to-date period as well as over the last twelve months. The S&P MidCap Index returned 3.6% in the most recent quarter, 17.6% year-to-date, and 53.2% over the last four quarters. The S&P SmallCap Index returned 4.5% in the most recent quarter, 23.6% year-to-date, and 67.4% in the last four quarters. The returns for these indexes over the four quarters and year-to-date periods show the extent of the market’s rebound from the lows of 2020 which followed the implementation of COVID related policies and the economic slowdown and chaos that followed.
The return differential in favor of small stocks represents a change in leadership among market sectors during the economic recovery. Similarly, the sector of the market populated by small capitalization value stocks has produced higher returns than the sector populated by large capitalization growth stocks. The S&P SmallCap 600 Value Index has experienced a return of 30.6% for the first two quarters of 2021, and a return of 77.3% over the last four quarters. During the same two periods, the S&P 500 Growth Index returned 14.3% and 41.4% respectively. The near-term change in relative returns for these two sectors shows a reversal of long-standing return differentials that once favored large growth stocks.
The change in equity market leadership was coincident with a Presidential election that brought with it a change in Administration and a promise of substantial changes in economic policies. The new promised policies included a shift to higher tax rates, increased government spending, increased regulations, and continued large Federal budget deficits. These policies, on the margin, tend to disadvantage large companies relative to small. For example, the plan to increase tax rates on overseas earnings tends to have a greater negative impact on the earnings of large companies versus small companies. Similarly, regulations are crafted to have the largest impact on large companies. Environmental regulations, such as limiting oil exploration and production, and expanded anti-trust initiatives have a greater impact on large companies than on small. Ultimately companies of every size feel the impact of increased tax rates and increased regulation, but in the near-term, increases in tax and regulatory burdens fall most heavily on large corporations. There was an episode of similar economic policies in the mid and late 1970’s, when companies like IBM, Xerox, and Eastman Kodak became the focus of anti-trust investigations, and the activities of oil companies were restricted. The consequences of government policies were unfortunate for these large companies.
The uncertainties that accompany new economic policies often buffet stock valuations. By the end of the second quarter the S&P 500 was valued at approximately thirty-eight times trailing twelve months earning. This valuation is above the long-term average of under twenty times trailing twelve months earning, however, the valuation on trailing earnings currently is distorted somewhat by the substantial decline in earnings brought about by the implementation of COVID related policies at the beginning of the twelve-month period. Looking at forward earnings estimates the market’s valuation is not quite as elevated. The current consensus estimate for earnings increases in 2021 centers around a thirty-five percent increase on a year-over-year basis. The market is valued at about twenty-one times this earnings estimate, and the multiple on estimated future earnings is close to average for the last thirty-five years.
The market’s behavior took place in a generally improving economic environment. The estimate for real economic growth in the second quarter centered in a range of 7.5% to 8.0% at an annual rate. The estimate for all of 2021 is approximately 5.0% on a fourth quarter versus fourth quarter basis. The unemployment rate for June was estimated to be 5.9%. The state-by-state unemployment rate shows disparities. The unemployment rate in Florida is estimated to be 4.9% while the estimate for New York and California are 7.8% and 7.9% respectively. Both New York and California implemented COVID related policies that constrained economic activity far more than those of Florida. If COVID driven constraints are eased, economic activity is expected to remain robust, and the unemployment rate should fall further.
A phenomenon complicating any analysis of unemployment is the decline in the labor force participation rate over the last twelve months. The rate has fallen by approximately 1.8 percentage points since COVID related policies were implemented. In the previous three years, the participation rate had drifted upward reversing a downward trend over the prior three decades. If the decline in the participation rate had not occurred, the end of June unemployment rate would have been over 7.0 %. Amidst the good news on unemployment there is the reality that the total number of jobs at the end of June remained five million below the level reached prior to the implementation of pandemic driven policies.
During the recent recovery, the US Treasury has run large deficits, and the Federal Reserve has monetized most of those deficits by buying about $120 billion in debt each month. The Fed’s balance sheet holdings have increased from approximately $3.4 trillion in March of 2020 to $6.0 trillion by the end of June 2021. This most recent runup in assets followed an earlier rapid increase in response to the financial market dislocations of 2008/2009 and the associated recession. Over the period from August 2008 through the end of June 2021, the Fed has added over $5 trillion to its balance sheet as it provided liquidity for various purposes. This rapid increase in the monetary base, Fed assets, has taken place with little or no uptick in inflation until recently. Inflation remained benign as the money supply has increased rapidly in large part because the velocity of money has declined as the money supply increased. By the end of the second quarter, inflation was approaching 5% at an annual rate. This rate is far above the Fed’s target of 2%. Concerns about the Fed’s response to these new data have grown. Investors anticipate a reduction in the money supply or rate of growth of the money supply that is part of an effort to combat rising inflation is likely to be accompanied by a rise in short-term interest rates and a slowing of economic activity.
The persistence of economic conditions consistent with further gains in stock prices will require astute monetary and fiscal policies going forward. Thus far, the economic recovery has been characterized by rapid real economic growth and relatively well-behaved inflation. Any action on the part of the Fed will of necessity consider fiscal policy. The current Administration has indicated its willingness to continue operating with large budget deficits while it increases overall tax rates and regulations. These policies could constrain the Fed’s activities, as inflation becomes a larger and persistent problem. Monetizing large budget deficits would be inconsistent with an effort to reduce inflation. Should the Fed choose to combat inflation while the Treasury runs large deficits and tax rates are increased, economic policies will mimic on the surface those of the late 1970’s when economic conditions included rising inflation, rising unemployment, rising interest rates, and negative real growth. However, in the 1970’s these conditions did not appear suddenly. They became evident only after unfortunate economic policy choices on the part of four administrations (Johnson, Nixon, Ford, and Carter). Policy makers have time to step back from the brink. Slow economic growth and rising inflation are not inevitable.