The Brave Report: Market Commentary for May 2021

Click here for .pdf version of this report: The Brave Report-May 2021

The Great Reopening…  With vaccine numbers continuing to rise and states throughout the country continuing to loosen COVID restrictions we are starting to see some semblance of a return to normalcy.  Economic data and earnings results from the first quarter also reaffirm that the economy is roaring back.  This economic growth is expected to continue as the government attempts to roll out a series of large spending bills and the spring and summer weather helps to add fuel to the reopening of states.  While it would be expected that this should add to continued upward momentum in the stock market (which I’m not saying can’t happen), it is important to remember that the markets are a forward-looking mechanism.  With the returns we saw last year and have seen to start the year there is a fear that much of this economic growth is already priced into stocks.

I do expect to see continued upward pressure in the markets in the mid to long term but would not be surprised to see some period of consolidation or weakness as the economic data continues to catch up with market prices.  With the potential of increased government spending, the markets will also need to hash out the potential impacts of inflation as we work toward a full reopening.

Market Overview

I feel like a broken record in recent months, but all three major indices continued to move higher, all reaching new all-time highs in the last week.  The NASDAQ and the S&P both advance more than 5% and the DOW gained around 2.7%. This brings YTD gains for the S&P and the DOW above 10%. The NASDAQ has lagged slightly but is still up around 8% so far this year. This represents one of the better starts to a year we have ever seen but it also gives me some pause. I, like most everyone, like to see the market go up but at some point, I think taking a breather would be healthy if we are to see these gains continue without a major correction. I would prefer to see a period of consolidation rather than a big pop followed by a big drop. There are some areas of the market and some specific names where this consolidation has already happened, but it needs to be broader.

On the fixed-income side, we saw rates stabilize after rising rapidly to start the year.  After peaking out around a yield of 1.75% at the end of last month, the 10-year spent most of the month trading around 1.6%.  The rate complex will be very interesting to watch in the coming months as the markets play ping pong with inflation concerns.  The strength and speed of the economic recovery will also play a large role in where rates go next.  Currently, there is a large spread of predictions for rates with some analysts predicting a full retracement back below 1%, with others expecting 2+% rates over the summer. If economic data continues at this pace and some of the government’s spending comes to fruition, I think a rise in rates is inevitable, it’s just a matter of when.

We have been getting new 1st quarter economic data almost every day over the last couple of weeks and it continues to reaffirm that the economic recovery is in full swing. Covid cases are down, and it seems each day a new state loosens their restrictions, adding more momentum to the economic recovery on Main St.  On Wall St., earnings data, so far, has also been positive showing that companies have been able to capitalize on the reopening.

With that said, much of this economic recovery was expected and the primary reason that the markets have been performing so strongly so far this year.  This begs the question, have the markets moved too far too fast?  We have seen this play out a bit during earnings season.  A number of names have put through extraordinary numbers, well above even the most optimistic expectation, but have not seen the expected stock price performance following their announcements.  Historically, this “buy the rumor, sell the news” mentality is a sign that much of the good news is already priced into the markets and can sometimes be a signal of a short-term top. Last year we saw a dynamic where there was a great dispersion between Main St. and Wall St. performance where economic data was terrible, but the markets were on fire. We could be entering an opposite scenario where Main St. economic data is stellar, but Wall St. performance lags because all the good data is already priced in.

Now it is important to point out that I am not calling for a large-scale correction in the markets but more a scenario where the stock market takes a bit of a breather while we continue to get economic data that validates the market’s current levels.  I think this would be healthy for the markets as we want to avoid entering a period of euphoria that then results in a much larger selloff.  I think this would allow a lot of names to create a base of support before the next move higher.

Another major variable we have seen enter the conversation is the fear of increased inflation as the economy roars back.  The kind of economic growth we have seen has historically led to increased inflation. Outside of the economic growth, the government has also proposed some major spending bills.  These are on top of the huge stimulus bills that were passed because of the pandemic.  We are still a long way from getting either of these new bills passed and I doubt they are passed in their proposed form but it is a clear sign from the administration that they intend to be aggressive in their spending agenda. This type of spending would also put quite a bit of upward pressure on inflation.

They have also been a bit unclear as to how they plan to pay for these massive spending bills.  A few proposals have been put forward to increase taxes on the very wealthy and increase capital gains rates but these are expected to be met with quite a bit of resistance from the other side of the aisle and I doubt would come close to footing the bill.  While the spending bills would increase economic growth and continue to help fuel the economy, until we know how they are going to be paid for it is difficult to handicap the impact on the markets.  If capital gains rates are used as a lever this could have a large impact on the markets since so many investors are sitting on so many gains. Until we know more about the plan though, we are just wasting our breath speculating about it.

No matter how they pay for it, this type of spending will have an impact on inflation.  The Fed does not seem overly concerned about rising inflation and in all their recent decisions have continued to stress that inflation is well within their long-term targets.  I think we are still in a wait-and-see time in terms of inflation.  Right now, much of the positive economic data is catch up from last year and this will continue for some time.  Until we are further beyond the recovery and returned to “normal” economic times it is difficult to understand what long-term impact the recovery has had on inflation.  In the meantime, I expect to see some volatility around the inflation debate since it would have a large impact on rates.

Strategy Commentary

My overall equity allocation has been consistent over the past month.  The economy continues to gain steam but throughout it, I have been hesitant to add to my equity allocation as I think we could be entering a period of consolidation.  With that said, I am also not reducing any of my exposure.  While we may see some weakness in the short term, I am comfortable holding the course.

I continue to maintain my overweight to technology.  There has been a bit of a rotation away from tech in the last few months but recent earnings reports, especially from the large tech names, have reaffirmed their strength.  I also think we have already seen some consolidation in the sector so they should be the names to lead us higher once the whole market has a chance to take a breath.  This overweight has definitely led to some underperformance in recent months, but I am still comfortable with my positioning. Within tech I am much more biased toward the larger, profitable names, rather than the speculative profitless ones. Domestically, I did trim some of my small-cap growth exposure and rotated it into mid-cap value as some of these names could benefit more from the recovery.

Internationally, I trimmed some of my broad emerging markets exposure.  With COVID raging in a few of the developing nations, I think being much more selective in my exposure is warranted.  I am still optimistic on China. It has pulled back over the past few months and I think this provides some selective entry points.  I am not rushing out but if we start to see some upward momentum I will be quick to add since I think the valuation picture looks quite strong there.

On the fixed income side we are kind of in no man’s land.  I continue to hold extra cash as a proxy for some of my fixed income exposure and until we get some directionality on inflation and rates I will maintain this positioning.  There isn’t enough yield right now to justify the risk of rising rates.