Market Outlook

August 31, 2021

Earnings And Lack Of Options To Drive Further Stock Gains


John Bonnanzio

Occasionally undermined by the Delta variant’s menacing advance, U.S. stock gauges crawled their way to record highs in August. In fact, late in the month, riskier small- and mid-cap stocks did what they haven’t done in months: They outperformed their large-cap counterparts.

By April of last year, stocks began to recover on the promise of several new vaccines. Early this year, mass-vaccinations began. The resulting decline in Covid infections and the reopening of the U.S. economy accelerated investors’ enthusiasm for stocks. And their willingness to put more cash to work in stocks intensified when their attention appropriately turned to company fundamentals — which dramatically improved.

With sales and earnings growth the inevitable by-product of a recovering economy, investors piled into equities — and they continue to do so. (Though often at a premium based on trailing price-to-earnings.)

The fund industry’s trade group, the Investment Company Institute, estimates that in July, $10 billion flowed into U.S. stock funds and ETFs. That’s a pittance. By comparison, in the single week ending August 18, inflows are thought to have surged to $13.7 billion. While fund flows don’t correlate well to market direction in the short-term, having more buyers in the market than sellers certainly helps to support share prices.

Ditto for earnings. On that score, the news is solid. Through mid-August, the 91% of reporting S&P 500 companies indicated a year-over-year earnings growth rate of 89% for the second quarter. That kind of earnings recovery hasn’t been seen since the end of the Financial Crisis in the fourth quarter of 2009.

The Only Game In Town

While the market understands that pace of earnings growth is unsustainable, there are other performance drivers that should continue to support stocks. One of the most important is the lack of competition from other asset classes.

Let’s first consider high-yield bond funds.

Thanks to the global economy rebounding, Fidelity’s eight offerings are all in positive territory this year. Balance sheets are improving and, according to Fitch Ratings, default rates are on track to hit a 10-year low. Granted, rising inflation is a headwind for all bonds. But junk bonds are more economically sensitive than they are interest-rate-sensitive. That’s one reason why High Income is up 3.7% this year, whereas Intermediate Bond is flat.

As for high-yield versus stocks, the former’s upside potential simply isn’t as great. Capital & Income (which holds stocks in addition to bonds) occasionally delivers equity-like returns. But it’s also about 70% as risky as the S&P 500. As a total return vehicle, high-yield bonds are delivering a good mix of income plus some capital appreciation. But as an asset class that has delivered only one-third of the returns of the S&P 500 (over the past decade), they’re insufficient competitors to U.S. stocks.

Bonds Versus Stocks

The yield on the 10-year Treasury note is 1.30% (it began the year at 0.93%). So bonds are not particularly attractive to income investors. Coupled with inflationary headwinds, their potential for keeping up with inflation is limited.

For example, Total Bond is one of Fidelity’s better-performing taxable offerings this year and is held in two models including our Income Model. Fine for that use, the fund yields 1.76% though it’s only up 0.6% for the year. Granted, it and other bond funds are safer than stocks. But in addition to their low yields, most bonds are pricey.

One measure of that "priciness" is a bond’s "real yield." That figure is calculated by subtracting from its yield the market’s expected rate of inflation over the next decade. In so doing, the 10-year’s real yield is now minus 1.03%. Two years ago, (pre-pandemic), it was a percentage point higher (minus 0.05%).

Of course, if high-yield bonds and “regular” bonds are no match for stocks, there’s certainly no need to compare stocks to money market funds — they essentially yield and return nothing.

Finally, there are REITs. As with other asset classes, they provide portfolio diversification. And, so far this year, plenty of gains. (Real Estate Index is up 29.6%.) But with relative volatilities that sometimes exceed stocks, and over longer periods usually don’t return as much, a good-ole-fashion stock fund is still the wiser choice.

Stocks: More Gains Ahead

Keeping in mind that anything from the Delta variant to a Congressional imbroglio over the budget could send stocks south, the outlook for the rest of the year is positive.

And Goldman Sachs agrees.

Last year, the investment banking colossus forecasted that the S&P 500 would rise this year from 3756 to 4300. Excluding dividends of 1.4%, that’s a return of 14.5%. More recently, higher corporate profits and stepped-up share repurchases have Goldman re-sharpening its pencil: They now see the index ending 2021 at 4700. That’s a gain of 25% (again, less dividends).

With the S&P 500 already up 21.6% this year, Goldman is forecasting stocks to grind their way about 1% higher through each of the remaining four months of this year. Yes, the “easy money” is already off the table. But with investors lacking viable alternatives, there may be more yet to be made in stocks.

 — John Bonnanzio