The first quarter of the year had its share of ups and downs, starting the year with violent political division that reached a fever pitch on January 6th and ending on a hopeful note as vaccination progress and more fiscal stimulus have boosted economic optimism and driven the market to record high levels, with the S&P 500 Index hitting the 4,000 level for the first time.
Value and Small Cap Outperform
A $1.9 trillion stimulus package accompanied by rising interest rates and expectations for increased inflation bolstered the performance of value names, economically-sensitive cyclicals, and small cap companies in the first quarter of 2021.
Conversely, big technology stocks and high growth names that had outperformed the most during the pandemic floundered. The performance gap was quite pronounced with the average large cap value fund gaining 11.4% for the quarter versus only 2.2% for the average growth fund over the same period, according to Morningstar.
The DJIA gained 8.3% and the S&P 500 TR Index was up 6.2%, in the first quarter, while the tech-heavy NASDAQ Composite trailed with only a 3% total return. The Russell 2000 Index of small cap names gained a whopping 12.7%. as they, along with cyclical stocks, are more sensitive to an economic recovery.
On a sector basis, the so-called “reflation trade” favored Energy (+29.3%), Financials (+15.4%), and Industrials (+11.0%) while Consumer Staples (+0.5%) performed the worst.
Meme Stock Collective and Archegos Blowup
All this market liquidity has led to some startling market excesses. No better example has been the “meme stock collective” as investors pooled their investment power on places like Reddit to move the share prices of favored stocks like GameStop and AMC. The collective sway on the meme-stock universe finally waned. “To quote Matt Maley, chief market strategist at Miller Tabak + Co., “people are going to be doing other things.”
The latest Google Trends tracker suggests that vaccinated Americans have switched gears and are now searching for vacations instead of “stock trading” and “investing”. The stimulus check impact on retail trading appears to be waning,” said Edward Moya, senior market analyst at Oanda. “Many Americans are looking to go big on attending sporting events, traveling across the country, vacationing, visiting family and friends, and revamping wardrobes before going out to restaurants, pubs and returning to the office.”
Another side effect of excess was the Archegos blowup. Archegos, a family office run by Bill Hwang, a “Tiger cub” protegee of hedge fund Tiger Management, was felled by margin calls on its 5X levered, concentrated positions, accumulating up to $10 billion in losses in just 10 days. Prime brokers Credit Suisse and Nomura experienced the worst collateral damage, while Goldman and Morgan Stanley beat them to the exits.
Rising Rates and Inflation
The overabundance of liquidity has also pushed inflation expectations to their highest level since 2014. As a result, bond yields on the 10-year treasury rose during the quarter from 1 to 1.75%.
Rising long-term rates contributed to U.S. Treasuries worst three months since the 1980’s with the iShares 20+ Year Treasury Bond ETF (TLT) down 13.9% for the quarter. Corporate bond funds held up better, but the iShares iBoxx Investment Grade ETF (LQD) still suffered a 5.5% loss for the quarter. High yield bonds (HYG), helped by their energy exposure, squeezed out a 0.58% positive return for the quarter. Muni bonds (MUB) were also up 0.66% as investors anticipate higher taxes ahead.
Inflation expectations have increased as investors fear that the flood of $3.6 trillion in new Treasury debt will erode the value of the dollar. But bond manager PIMCO predicts that while inflation may rise modestly this year, challenges reaching full labor employment will keep inflation in check. That’s an interesting stance from a firm that has sizable products in Treasury Inflation Protected Securities (TIPS). PIMCO expects core inflation to remain below central banks’ targets in all major economies this year and next. The Federal Reserve’s target is 2%. As a result, they see potential for an “inflation head fake” meaning future opportunities on longer-dated yields.
Earnings season will soon be upon us, and expectations going into the second quarter are quite high, resulting in historically high market valuations. According to Bloomberg, the forward 12-month P/E ratio for the S&P 500 was 22.7 at the end of Q1, which is well above the 5-year (17.8) and 10-year (15.9) averages.
FactSet estimates put the Q1 EPS growth rate for S&P 500 companies is 23.3%, which is up from the 15.8% growth forecast expected at the start of the quarter. Revenues are expected to grow 6.3%, which is up from forecasts of 3.9% at the start of the quarter.
While valuations are meaningfully elevated versus historical norms, the bullish case for stocks is unprecedented. Massive fiscal stimulus (25% of GDP) coupled with a strong vaccine rollout (30% of U.S. population) have exceeded previous quarter expectations. Accordingly, economic data and future projections continue to improve with U.S. GDP now forecasted to grow at its fastest pace (7%) since 1984 and unemployment falling towards 5% by the end of 2021.
While the path ahead is sure to be bumpy, the reopening of the economy and massive stimulus efforts in place should continue to buoy equity markets in the second half of the year as the market strikes a balance between post-pandemic optimism and the level of future expectations. As behavioral finance has taught us, investors tend to react inefficiently to change, so the balancing act will continue.
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