Executive Summary

  • The U.S. economy grew at an annualized 6.4% rate in the first quarter of 2021, driven by a historic surge in consumer spending. The big question is: How much is already baked into the markets?
  • The bull case for stocks is supported by the improving economy, massive monetary accommodation efforts, and fiscal spending, as well as record-breaking corporate profits.
  • The bear case for the market rests on stretched valuations, overheating, and inflation concerns, as well as proposed tax legislation.
  • U.S. equities continued marching higher in April, while the bond selloff faded. The top performing asset class was Commodities, which rallied on supply and demand dynamics.
  • It’s important to distinguish between the market and the economy, which don’t always move in tandem. Despite the improving economic backdrop, it is imperative to recognize this dichotomy as we position our portfolios.

What Piqued Our Interest

Spring is finally here, and unless you’re suffering from seasonal pollen, you’re probably in a good place, as the new season is ushering in a sea of positive change. Not only have the days gotten longer and the weather warmer, but the U.S. has moved closer to herd immunity, with the population getting vaccinated and state after state lifting most of their COVID-19 restrictions this month. This, of course, means that more of the unemployed should be able to reenter the workforce. However, the April jobs disappointed on all fronts, as just 266,000 new jobs were created—well short of consensus expectations of 975,000. This just goes to show that despite the significant improvements of late, we still have a long way to go.

On April 29, the advance estimate of first quarter GDP came in at an impressive level of 6.4% (annualized), which was the second-highest quarter of growth since 2003—bested only by the third quarter of last year. Following a 4.3% climb in the fourth quarter of 2020, the increase in the first quarter reflected the continued reopening of the economy, along with government stimulus—most notably the $1,400 direct payments that were part of the American Rescue Plan. Consumer spending, which constitutes almost 70% of the U.S. economy, surged by 10.7% in the quarter, with impressive gains in goods (+23.6%) and services (+4.6%), with the latter being the more troubled component of the economy. For the year 2021, analysts are expecting 6.5 – 7% GDP growth, which would be the highest level of growth in 37 years.

With all this growth, you might say to yourself, “What’s there to worry about?” Many of us know the market adage, “sell in May and go away,” which may seem relevant given the impressive run the market has been on. After all, going back to 1928, the average return for the S&P 500 in May is -0.1%—only behind September (-1.0%) for second worst. We bring this up because the market may be at a crossroad, whereas the plethora of good news has been baked in against a conflux of worries surrounding the economy overheating, rising inflation expectations, and stretched valuations. Let’s look at each case in isolation.

The bull case for the market remains strong, which is why the path of least resistance for equities may remain higher. The Fed continues to purchase $120 billion in Treasuries per month, which has helped fuel the rally for riskier assets that began last March. At the recent FOMC meeting, Fed Chair Jerome Powell reiterated that now is not the time to begin discussing tapering bond purchases, and substantial progress will have to be made before any changes are considered. Regarding inflation, he made it clear that a transitory rise in inflation wouldn’t warrant a rate hike, and inflation can exceed their long-term 2% target for an extended period. On the other side of Washington, President Joe Biden and Congress are unveiling bold and massive spending plans aimed at improving the country’s infrastructure, amongst several other initiatives, which all add up to $6 trillion of stimulus—on top of the $3.6 trillion spent or committed in 2020. While somewhat controversial in terms of their size and scope, in aggregate, the plans should boost the labor market and provide yet another jolt to the economy in the short-to-medium run.

Beyond the dually accommodative policies of the government, there are more reasons to be constructive on the markets. Corporate earnings continue to surpass expectations in momentous fashion. Through April 30, 60% of the S&P 500 had reported earnings, with 86% of those companies reporting a positive earnings surprise—the highest level going back to 2008, according to FactSet. Analysts have also increased estimates for the second quarter by an additional 4.2% and are now projecting earnings growth of 58.3% in the second quarter and 32% for the year 2021. The record earnings results, combined with strong equity inflows, corporate buybacks, and continued momentum towards the economic recovery, could all support higher equity levels in the coming months.

Figure 1. Equity Risk Premium (S&P 500 Earnings Yield—10-yr. Treasury)

equity risk performance

Source: FactSet, as of 4/30/2021

The bear case for stocks is primarily centered on stretched valuations, inflation concerns, a Fed policy mistake, and concerns surrounding a potential tax overhaul. Valuation measures of equities such as Price-to-Earnings (P/E) ratios have been elevated for several years, especially in comparison to their historic averages. Another way to look at it is by comparing the earnings yield of stocks (the inverse of the P/E ratio) to the yield on a risk-free* 10-year Treasury. This is one way to calculate the Equity Risk Premium (ERP); that is, the amount of return one requires for taking risk above the risk-free rate. The ERP recently touched below 2.8%, which is close to its lowest point in over a decade, as Figure 1 above demonstrates. This indicator alone validates a more cautious tone when evaluating equities.

Another major concern that has been immensely debated over the past few months is whether the current surge in prices is transitory, or whether we may be headed towards a prolonged period of rising inflation. The Fed is certainly in the former camp, as Powell has repeatedly stated that the rise in prices is justifiable given the low base effect, as well as the surge from reopening service sectors. However, more companies are reporting price increases, which has become a dominant theme for corporations during earnings season. Chief executives across a broad band of sectors have told analysts they expect to raise prices this year to offset rising input costs, from daily household goods, to fast food, to appliances, and beyond. Widespread commodity shortages have stoked inflation fears; one notable example is lumber futures, which are up almost 100% year-to-date (YTD) and over 600% since April of last year. While the momentum behind building supplies will likely subside once the economy fully opens, the concern is that continued stimulus and pent up demand, along with wage increases once we near full employment, could result in a more permanent period of inflation and economic overheating. The 10-year breakeven inflation rate recently pushed above 2.4% at the end of April—a level not seen since 2013.

A final concern that has some investors on edge relates to the pending tax increases proposed by President Biden as part of the American Family Plan. Without getting into the details of the proposal, critics claim that an increase on the long-term capital gains tax, as well as the removal of the step-up in basis rule, could spark a selloff before the new rules go into place. While not entirely without merit, past instances of tax increases have not resulted in sustained market drawdowns. In fact, an evaluation of the past four increases in capital gains tax has resulted in higher returns on average over the following 3, 6, and 12 months.

s&p returns

Source: LPL Research, Ned Davis Research, FactSet

Market Recap

may market recap

Equities once again rallied to start off the second quarter, with the MSCI All Country World Index climbing 4.37% on a total-return basis. The S&P 500 gained 5.34% in April—its largest monthly gain of 2021 so far—and is now up almost 12% for the year. The growth-to-value rotation took a pause last month, as the Russell 1000 Growth Index outperformed its Value counterpart for the first time since January by a 6.8% to 4.0% margin. Leading sectors included Real Estate (+8.3%), Communication Services (+7.9%) and Consumer Discretionary (+7.1%). Real Estate no doubt was helped by a pause in the rates rally (more to follow), while Communication Services and Consumer Discretionary were boosted by strong earnings results and the resurgence of the U.S. consumer. The Energy sector gained only 0.59% in April but is still the leading sector YTD—up over 31%. Other historically defensive sectors such as Staples, Utilities, and Health Care all had respectable gains but continue to trail the broader market YTD. Small Caps, as represented by the Russell 2000 Index, gained 2.1% last month but are still outperforming Large Caps by a 3% margin this year.

The MSCI All Country ex-USA Index trailed the U.S. as it gained 2.94% and is now positive 6.54% YTD. Developed International stocks modestly outperformed Emerging Markets, which has been a trend the past several months as countries from western Europe notably outperformed Asia overall. The FTSE Developed Europe Index climbed 4.6% and is up 8.8% YTD, compared to the Developed Asia-Pacific Index, which gained 0.7% and 3.5%, respectively. The Emerging Market Index was hindered by another slow month for China, which edged higher by 1.4% and is up less than 1% for the year. According to a JP Morgan analyst, weak performance in China can be attributed to negative capital flows, as well as a weakening Yuan relative to the U.S. dollar.

Moving from stocks to bonds, the historic backup in rates finally took a pause last month, as the yield on the 10-year edged lower from 1.74% to 1.63%. The Bloomberg/Barclays U.S. Aggregate Bond Index recouped some of its losses and is now lower by -2.6% YTD. The U.S. Corporate Investment Grade Index gained 1.11% in April but is still down -3.59% YTD. The option-adjusted spread on the Corporate Index is just 0.88% over comparable Treasuries—just a few basis points above its 15-year low of 0.82%. The same can be said for High-Yield (below investment grade) Credit, which has a spread of just 3.28% over Treasuries—versus its 15-year average of 4.77%. The High-Yield Index did increase by 1.09% last month and is one of the top-performing bond sectors YTD at +1.95%.

The biggest mover in April was the Commodities sector, which gained 8.29% for the month and is up 15.78% YTD. Pent up demand, a resurgent housing market, and supply chain disruptions have all been factors that have led to the overall rise in materials over the past several months. All Commodity subsectors were higher for the month, but the largest gains were in Agriculture (+15.03%) and Natural Gas (+12.39%). Industrial Metals bested Precious Metals by a 9.83% to 3.3% margin, as broad demand stemming from the recovery has been a boon for the sector. WTI Crude Oil recovered its March losses, climbing 7.3% in April and over 31% this year. This occurred as the U.S. dollar declined -2.09% against a basket of currencies but is still modestly higher YTD (+1.45%).

Final Thoughts

There is no shortage of justifications as to why the market might climb another 15% this year or why it might collapse by a greater amount. Both the bull case and the bear case have their merits, and as investors, we need to carefully consider the implications on both sides. It is clear there are enormous tailwinds for the market based on pace of the economic recovery. However, we must always keep in mind that the markets and the economy are two different entities that can behave very differently for extended periods. While over the long run we expect the market to outperform, the short run can be much more unpredictable, so we must stay vigilant and be cognizant of the near-term risks.


* Government bonds and Treasury bills are guaranteed by the U.S. government as to the timely payout of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value.


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

Gary Quinzel

Gary Quinzel

Senior Portfolio Manager

MBA, CFP®, CFA® Gary began his career in investment strategy and management in 2003. He is highly-skilled in the areas of macroeconomic research, portfolio management and investment analysis. Gary also enjoys delivering market commentary and guidance to clients. He lives in Morris Township, NJ with his wife Andrea and their daughter Avery. In his free time, you will find Gary spending time in the outdoors, running and playing sports. MBA, Seton Hall...Read More