What to buy as the stock market shifts to another gear
“Peak growth” has become the latest bogeyman in the markets. It’s the buzzword nowadays to discuss the rate of change in corporate profits, U.S. gross domestic product, stock prices, government and central bank stimulus, and the inflation. This is the trend that matters to investors, and the outlook is for a deceleration on several of these fronts.
It’s a recognition that the easy money was made in the post-pandemic bull race long ago, and that markets and the economy are entering more uncertain mid-cycle periods. This has brought quality stocks back in favor, while putting some of the biggest winners in recent quarters to the curb. Economically sensitive
energy stocks, for example, have fallen into corrective territory since June, as has strong speculative growth from Cathie Wood
exchange traded fund (ticker: ARKK). The breadth of the market has narrowed as a small group of winners, such as the Big Tech stars, have kept the indexes in the air.
Dow Jones Industrial Average
last week, the index fell 182.31 points, or 0.52%, to 34,687.85. The S&P 500 slipped 0.97% to 4,327.16, and the
lost 1.87%, to 14,427.24. Everyone still finished within a few percentage points of their record. T-bill yields rose, then fell, with the 10-year yield surpassing 1.4% after the latest inflation data was released on Tuesday, then falling back to 1.3% to end the week below of what she had started. The curve flattened as short-term rates held up.
The momentum suggests a summer lull after a hectic year, as the market, politics and economy move into their next phases.
The second quarter earnings season should strengthen that narrative. The S&P 500’s earnings per share are expected to increase 62% from a year ago, according to data from Yardeni Research. It’s the growth of gangbusters. But investors know it’s coming. Stocks have hit all-time highs and rich multiples this year as they wait for a post-pandemic rebound that is now showing in the numbers. It follows a 48% growth in EPS in the first quarter and expectations of 23% and 17% in the third and fourth quarters. In other words, the peak of profit growth is here.
The result is that the market faces a tough bar this earnings season: the combination of unprecedented pricing and very high expectations. Actions will be punished if they disappoint and will not be rewarded if they simply meet expectations. The big banks and other financial firms kicked off last week and beat earnings expectations by around 26% overall. But their shares were almost universally sold:
Goldman Sachs Group
(GS), JPMorgan Chase (JPM) and
Bank of America
(BAC) broke expectations and traded lower immediately thereafter.
The coming weeks should bring many negative reactions to large but expected earnings, as well as management commentary on the impact of inflation on margins in the next quarter.
The first official estimate of US GDP for the second quarter is due in late July. Much like earnings, it should be a blistering growth rate, but the peak of this business cycle. The consensus of economists predicts a seasonally adjusted annual growth rate of 9.5% over the April-June period, after a 6.4% pace in the first quarter. After China, which announced a deceleration in the rate of GDP growth last week, the US economy could see its expansion slow in the second half of the year. Still good growth, but less.
Inflation and the Federal Reserve’s next move remain a source of uncertainty. “Inflation has risen dramatically and will likely remain high for the next few months before moderating,” Fed Chairman Jerome Powell confidently told Congress last week. He reiterated the central bank’s optimistic stance on inflation being a temporary side effect of the ongoing economic reopening.
Nonetheless, a 5.4% year-over-year increase in the consumer price index in June raised eyebrows for some last week. The majority of the price increase comes from new and used cars, out-of-town accommodation, and airline tickets, all of which can reasonably be expected to subside as the reopening is regulated. But wages and primary housing costs have also increased, which is seen as a more rigid form of inflation.
âThe bad news is that we are still not out of the woods, because [inflation measures] are expected to remain high through the end of the year and early 2022, âBofA Securities economists wrote last week. “The good news is that we are probably near the peak, at least for the next few months, as base effects are less favorable and scarcity pressures shift from goods to services.”
The focus on gradually reducing bond purchases and increasing interest rates will only increase in the coming months. The next meeting of the Fed’s rate-setting committee will be July 27-28, followed by its annual policy symposium in Jackson Hole, Wyo. a month later and another FOMC meeting three weeks later. One of them will almost certainly serve as a forum for the unveiling of the Fed’s reduction schedule, which could begin in late 2021 or early 2022.
Put it all together, and the most compelling stocks in the coming months should be those of companies that can control their own destiny without needing to rely on the tailwind of the rising tide that lifts all boats of the rapid post-pandemic recovery. – and can withstand the negative effects of high inflation and a change in monetary policy.
âIt’s about quality, predictability and security,â says Robert Phipps, director of Per Stirling Capital Management. “The next few months are really going to reward these boring, boring stocks at the expense of almost everything else in the market.”
Phipps highlights Big Tech stocks as
(FB) as beneficiaries of such an environment. They are long-term proven producers with high profit margins. Each is less dependent on the economic environment than cyclicals and relative valuations cheaper than many other popular software stocks.
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Alphabet also makes a display of quality companies with defensive attributes and above average earnings trends managed by
strategists last week.
(AMGN) are also on the list.
The US economy is not on the brink of a recession, and third quarter earnings growth will still be very strong. But it’s the trend that matters, and investors never settle for what they have. It can’t hurt to stick with quality while the market determines what’s next.
Write to Nicholas Jasinski at [email protected]