Our process has been positive about the intermediate term outlook for the stock market, but cautious about the short term, for several months now. The average stock, as measured by several different indicators, stopped going up in June. The S&P 500 index, on which larger companies have more influence, was dragged higher through its recent peak on September 2nd by a few large companies. From May 31st to September 2nd, just 6 mega-cap stocks in the S&P 500 accounted for 55% of the index’s performance, according to data from Dwyer Strategy. Thankfully, most clients own several of those stocks! Historically though, when few stocks are participating in an upward trend, there is more risk in the market.
There are many possible explanations for the market’s recent decline, both political and economic. We don’t know what the exact cause is, though they probably all have some validity. And when conditions are ripe for a pullback, especially after nearly a year without one, the market finds an excuse to fall. However, our process tells us that this decline will be relatively short-lived, and sets up opportunity through the end of the year.
Economically, we point out that the Conference Board’s leading economic indicators are still strongly positive regarding growth 6-9 months out. Unemployment should continue to decline into 2022. A historic economy-wide backlog of manufacturing orders and healthy credit markets should also support growth going forward.
Looking at the market itself, fears about the effect of inflation on the stock market are largely unfounded, at least for the foreseeable future. Inflation can improve the earnings of companies with pricing power, and historically stocks have performed best when interest rates are low and rising. Valuations have come down as companies’ earnings growth has outpaced price gains year to date. We expect earnings to continue to rise rapidly in the quarters ahead.
Stock market action since the peak in early September is relatively positive as well. Traditionally higher-risk and more economically sensitive areas of the market, such as small cap stocks and energy, have performed better than the broad indexes, while traditionally defensive areas have lagged. This is the opposite of what you would expect if the market was foreshadowing a big decline. Ultimately, we will invest any excess client cash when our indicators suggest it is appropriate; likely sometime in the next few weeks. This summer of indigestion is close to clearing the stage for a year-end rally.
