We expect the strong economic recovery to continue to drive strong earnings growth and support further gains for stocks [Figure 6]. However, after one of the strongest starts to a bull market in history — including a nearly 90% gain off the March 23, 2020 lows through June 28, 2021 —stock prices reflect a lot of good news. As inflationary pressures build and interest rates potentially rise further, though, the pace of stock market gains may slow.

History doesn’t repeat, but it often rhymes

Although no one would argue this cycle looks like any other we’ve experienced in modern history, studying the second years of historical bull markets — as we also did in our Outlook 2021 —can be instructive.

Looking back at all of the bull markets since 1950, the average S&P 500 gain during the second year has always been about 13% [Figure 7]. Achieving that return would put the index slightly over 4,400, and within our target range. However, when focusing on bull markets that followed declines of 30% or more – as the current one did – the average gain during the second year has actually been 17%. Following that pattern would put the index near 4,600, and well above the high end of our year-end fair value target range.

Volatility and other bumps on the road ahead

Looking at pullbacks (5-10% decline) and corrections (10-20% decline) during the second years of historical bull markets, we can get an idea of the type of volatility the stock market might experience in the second half of 2021 – or in early 2022. The average maximum drawdown for the index during those two-year-old bull markets has been about 10%.

In the second year of the 2009 bull market, the index corrected about 17% [Figure 7]. Given the jolts from the reopening and the stimulus still working its way through the economy, pullbacks may be short-lived and corrections less severe. Inflation that proves longer lasting than the Federal Reserve expects could drive interest rates sharply higher, and ranks at the top of the list of potential causes of a correction. Tax increases, COVID-19 spread outside the U.S., and geopolitics are among other possible bumps in the road.

Earnings outlook gathers speed

Coming off a stunning first-quarter earnings season with one of the biggest upside surprises ever recorded, corporate America is firing on all cylinders. Not only are earnings expected to ramp up significantly over the remainder of 2021 – as the economic rebound continues – but estimates have risen significantly since the start of the year.

Reflecting the tremendous strength in corporate profits, our forecast for S&P 500 earnings per share (EPS) in 2021 is $195 – a 36% increase from 2020 – and up from our $165 estimate at the start of the year. We believe our forecast – which is above the current consensus estimate – is reasonable, given the strong economic growth outlook and massive amount of fiscal stimulus still working its way through the economy. We expect corporate America to build on its strong earnings performance in 2022. Our 2021 year-end S&P 500 fair-value target range of 4,400-4,450 is based on a PE of 21.5, and our 2022 S&P 500 EPS forecast of $205.

While the economic recovery looks very likely to drive strong revenue growth, inflation could present risk to corporate profit margins and weigh on earnings. Companies may see upward pressure on wages – if the labor market tightens further as more of the economy reopens. Supply shortages, higher commodity prices, and rising borrowing costs could also erode the profitability of U.S. companies. U.S. businesses are also closely monitoring policy developments, as a potential increase in the corporate tax rate would have immediate impact on their bottom lines.

Low interest rates providing shock absorber for valuations

Strong earnings have helped stocks grow into their valuations. However, based on the most common valuation metrics such as the price-to-earnings ratio (P/E), stock valuations remain elevated. The S&P 500 Index is trading at a forward P/E of 21 times the consensus earnings estimate for the next 12 months. This is above the post-1980 average of 17 (source: FactSet).

However, when incorporating interest rates to get a more complete picture, we find stocks are actually reasonably priced. Based on 2021 forecasts, the S&P 500 earnings yield (the inverse of the price-to-earnings ratio) is about three percentage points higher than the 10-year Treasury yield – or the “earnings” that Treasuries generate. This “equity risk premium” is well above the long-term average of 0.8%, indicating stocks are cheaper than bonds in an “apples-to-apples” comparison.

If inflation risk remains manageable throughout the year – as expected – and yields rise only gradually, we’d expect earnings growth to continue to support stock market gains.

Style rotation has more horsepower

The economy’s transition to a durable and lasting expansion positions cyclical stocks to outperform defensives in the second half of the year. In this environment, the value style will likely outperform growth. The financials, industrials, and materials sectors may also be positioned for solid gains. However, the growth style won’t go quietly, given technology’s tremendous earnings power.

Small caps to set the pace

Small cap stocks historically have outperformed early in bull markets. Small cap valuations are still reasonable, despite strong gains since March 2020. In our view, this is supported by a strong earnings rebound.

Developed international stocks no longer spinning their wheels

The improved value-style performance has opened the door for developed international stocks to potentially outperform U.S. stocks for the first time in over a decade. The recovery the U.S. is currently experiencing from COVID-19 still lies ahead for Europe and Japan.

Emerging markets could hit some speed bumps

As the developed world continues to recover from the pandemic, emerging markets may lose some relative appeal. While valuations are attractive and the U.S. dollar may weaken, geopolitical and regulatory threats may limit gains for the China-heavy emerging markets index.

Looking at the road ahead

We expect additional gains for stocks in the second half of the year. However, they’re likely to come at a slower place – with some bumps along the way – as inflation picks up and concerns about the Fed pulling back monetary support intensify.

 

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